Residual Dividend

Residual dividend is a dividend policy that companies use when calculating the dividends to be paid to shareholders. Companies that use resident dividend policy fund capital expenditures with available earnings before paying dividends to shareholders. The policy creates volatility in the dollar amount of dividends paid to investors each year. The first priority for a company using residual dividend policy is to use earnings to cash flow capital expenditures, and dividends are paid with any remaining earnings generated by the firm.

A company’s capital structure typically includes both long-term debt and equity, and capital expenditure can be financed through a loan or by issuing more stock.

When a business generates earnings, the firm can either retain the earnings for use in the company or pay the earnings as a dividend to stockholders. Retained earnings are used to fund current business operations or to buy assets. Every company needs assets to operate, and those assets may need to be upgraded over time and eventually replaced. Business managers must consider the assets required to operate the business and the need to reward shareholders by paying dividends.

As an example, a clothing manufacturer maintains a list of capital expenditures that are required in future years. In the current month, the firm needs $100,000 to upgrade machinery and buy a new piece of equipment. The firm generates $140,000 in earnings for the month and spends $100,000 on capital expenditures. The remaining income of $40,000 is paid as a residual dividend to shareholders, which is $20,000 less than was paid in each of the last three months. Shareholders might be disappointed when management chooses to lower the dividend payment, and senior management must explain the rationale behind the capital spending to justify the lower payment.

While shareholders may accept management’s strategy of using earnings to pay for capital expenditures, the investment community analyzes how well the firm uses asset spending to generate more income. The return on asset (ROA) formula is net income divided by total assets, and ROA is a common tool used to assess management’s performance. If the clothing manufacturer's decision to spend $100,000 on capital expenditure is the right one, the company can increase production or operate machinery at a lower cost, and both of these factors can increase profits. As net income increases, the ROA ratio improves, and shareholders may be more willing to accept the residual dividend policy in the future. However, if the firm generates lower earnings and continues to fund capital expenditures at the same rate, shareholder dividends decline.