Page 211 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes (ii) Preserving the assets worth of the business;
(iii) Generating a sufficient cash flow out of profits to provide capital for expansion; and
(iv) Providing funds for research, and development of new and improved products to replace
the existing products before they decline.

9.1 Management of Profits

From the point of view of dividend decision it is better to call management of profits as
management of earnings. Earnings mean net earnings available to equity shareholders from
where a firm actually declares dividends or retain profits for financing of investment
opportunities.
Net earnings = Operating Profit – (Interest + Tax + Preference Dividend)

Management of earnings means, how the earnings of a firm are determined and how they are
utilized or appropriated or allocated or distributed. In other words, how the business firm
apportions their earnings is between dividends and retentions for financing of investment
opportunities. Retention of earnings' is also known as plough back of profits. Management of
earnings is an important finance activity of a business undertaking. Since proper management
of earnings helps to maximise shareholder's wealth particularly in Joint Stock companies where
owners are different from the management team, who are selected/appointed by owners, usually
management team or Board of Directors (BODs) do not distribute the total net earnings to the
shareholders as dividends. They may retain a part of it for financing of investment opportunities
or expansion program by keeping future growth of the firm in mind. Management of earnings
policy must maximize value of the firm, thereby maximize benefits to its owners. On the other
hand improper retained earnings and absence of financial control measures are the indicators of
inefficient management of earnings that may not help to maximize value of the firm, but they
may lead to the liquidation of the company.

9.2 Dividend Policy

As we have seen in the above, management of earnings means allocation of earnings among
dividends and plough of profits. The term 'dividend' refers to that portion of company's net
earnings that is paid out to the equity shareholders (not for preference shareholders, since they
are entitled to have a fixed rate of dividend). Dividend policy of a firm decides the portion of
earnings is to be paid as dividends to ordinary shareholders and the portion that is ploughed
back in the firm for investment purpose. The total net earnings of equity may be paid as dividends
(100% dividend payout ratio), which may consequently result in slower growth and lower
market price or a part of net earnings may be paid as dividends, higher capital gains and higher
market price. When a company uses a part of its net earnings for dividend payments then, the
remaining earnings are retained. Thus, there is an inverse relationship between retained earnings
and payment of cash dividend-the larger the cash dividends and lesser the retention, smaller the
cash dividends and larger retentions. Hence, the alternative use of net earnings or net profit
dividends and retained earnings are competitive and conflicting.
Dividend decision affects the value of the firm. The cash available for the payment of dividends
is affected by the firm's investment decision, and financing decision. A decision, which is related
to investment leads to less cash available for payment of dividends. Thus, there is a relation
between investment decision and financing decision. Distribution of net earnings between
dividends and retention would obviously affect owners' wealth. Now the company is in dilemma
which alternative is consistent to maximize shareholders wealth. The firm has to pay dividends
to shareholders if dividends lead to the maximization of wealth for them, otherwise the company
should retain them for financing profitable investment opportunities.

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