For some reason, I’m having difficulty grasping the following:
Paying a cash dividend is most likely to result in:
A) an increase in liquidity ratios. B) the same impact on liquidity and leverage ratios as a stock dividend. C) an increase in financial leverage ratios.
I understand why it’s not A or B. But I want to understand why its C.
The reasoning given is that acash dividend will increase leverage ratios such as debt-to-equity and debt-to-assets, reflecting a decrease in the denominator. It seems like such a simple question, but I just can’t seem to get the relationship between cash dividend and financial leverage ratios. Any help is much appreciated.
The question is poorly written, in the sense that it ignores the reality of dividend payments; at best, it’s ambiguous.
What they want you to think is that the dividend is delcared and paid all at once. In that case, assets are reduced by the amount of the dividend (cash is paid), equity is reduced by the amount of the dividend (retained earnings are reduced), and liabilities are unchanged. Financial leverage is Debt/Equity, or Debt/Assets: the numerator stays the same, the denominator gets smaller: the ratio increases.
The problem is that in the real world, when the dividend is _ declared _ (but not yet paid), retained earnings decrease and liabilities increase (assets are unchanged): Dividends Payable increases. At that point, Debt/Assets increases and Debt/Equity increases. When the dividend is paid , assets decrease and liabilities decrease (equity is unchaged), so Debt/Assets decreases (a larger percentage drop in Debt than in Assets), and Debt to Equity decreases (liabilities drop, equity doesn’t change).
Yes as per S2000 magician, Financial leverage ratio have an item that will decrease denominator when we will pay cash. For example- Debt / Assets increases when we will pay dividends in cash( because cash is our current asset), so it will reduce denominator and increase in ratio.
Debt/Equity- It will also increase when we will pay cash because it will reduce our retained earnings(hence by equity). This result increase in ratio.
Here the numerator is decreasing by 10 which is only 10% of the previous value, But the denominator is decreasing by 10 also which is 25% of the previous value that’s why denominator is decreasing more.