Page 295 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 14: Management of Surplus & Dividend Policy

Profit is the primary motivating force for any economic activity, a business enterprise essentially Notes
being an economic organization, it has to maximise the welfare of its stakeholders. To this end,
the business undertaking has to earn profit from its operations. Profit is the excess of revenue
over expenses on conducting operations. In fact, profits are useful intermediate beacon towards
which a firm’s capital should be directed. In this connection McAlpine rightly remarked that
profit cannot be ignored since it is both, a measure of the success of business and the means of its
survival and growth. To quote Bradly, “if an enterprise fails to make profit, capital invested is
eroded and if this situations, prolongs the enterprise ultimately ceases to exist.” A well organised
profit planning programme will help towards maintaining a level of profit, which will ensure
the concentration of the business and fulfillment of other responsibilities. Certainly, profit
growth coupled with high level of profit and the ability to maintain reasonable profit will help
towards:
1. Ensuring that shareholders receive an adequate dividend;

2. Preserving the assets worth of the business;
3. Generating a sufficient cash flow out of profits to provide capital for expansion; and
4. Providing funds for research, and development of new and improved products to replace
the existing products before they decline.
14.1 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
utilised 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 earning’s 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) does 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 programmes by keeping future growth of the firm in mind. Management of
earnings policy must maximise value of the firm, thereby maximise 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 maximise value of the
firm, but they may lead to the liquidation of the company.

When a corporation makes a profit, it can spend that profit in two ways:
1. Return the profits to stockholders by way of dividends, share buy-backs or bonus issues;
2. Use the money to increase the profitability of the company

Example: A company makes a profit of 100. It can pay this entire amount to stockholders
who can then use that money as they think fit—spend on consumer items, make further
investments, whatever. Or the company can use all that profit to invest in the business with a
view to increasing profits in future years. Or the company can do a bit of both.

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