Why Would a Company Drastically Cut Its Dividend?

Companies can do several things with their profits. They can keep them as retained earnings, reinvest them to help them grow, or share them with their investors as dividends. Dividend payments are decided by the board of directors and must be approved by shareholders. These payments can be issued as cash or as shares of stock.

But what happens when a company needs to cut its profit-sharing? A dividend cut occurs when a dividend-paying company either completely stops paying out dividends or reduces the pay out. This most often leads to a sharp decline in the company’s stock price, because this action is usually a sign of a company’s weakening financial position, which makes the company less attractive to investors.

Key Takeaways

• Dividend cuts are most often a negative sign for a company’s financial health.
• Companies usually make drastic dividend cuts because of financial challenges like declining earnings or mounting debts.
• Sometimes companies may cut dividend payments for more positive reasons, like preparing for a major acquisition or a stock buyback.

Financial Reasons

Dividends are usually cut due to financial reasons like weak earnings or a funding crunch. Typically, dividends are paid out from the company’s earnings, and if earnings decline over time, the company either needs to increase its payout rate or access capital from other places, such as its short-term investments or debt, to meet the past dividend levels. 

If the company uses money from non-earnings sources or takes up too much of the earnings, it may put itself into a compromising financial position. For example, if it has no money to pay off its debts because it is paying out too much in dividends, the company could default on its debts. It usually won’t come to this, though, as dividends are usually near the top of the list of things cut when the company is faced with financial challenges.

This is exactly why dividend cuts are seen as a negative. A cut is a sign that the company is no longer able to pay out the same amount of dividends as it did before without creating further financial difficulties.

Note

Some of the most common industries that pay dividends include financials, oil and gas, utilities, healthcare, and basic materials.

Room for Growth

While most investors rightly consider a drastic dividend cut a negative sign for a company’s health, it isn’t always such a harbinger of doom for a company. 

Under certain conditions, when the pricing and conditions are just right for a stock buyback; weathering a major recession becomes the priority; or a company needs to accumulate cash on hand for a big merger or acquisition. 

In these cases, a dividend cut—even a rather drastic one—may not necessarily be a sign of trouble or even a sign that selling the stock is your best course of action. As with any financial decision, doing due diligence and careful research is key to successful investing. 

Examples of Dividend Cuts

Although most dividend-paying companies do everything they can not to slash them, there are cases when companies have no other alternative. The following are a few cases when companies decided to cut their dividends:

• Royal Caribbean Cruises: The cruise holding company suspended its quarterly dividend in 2008 as a cost-cutting measure. The aim was to improve the company’s profitability and liquidity.
• Wells Fargo: The bank cut its dividend by 85% in 2009 following the financial crisis. Originally 34 cents, Wells Fargo’s dividend dropped to five cents as a way to help cushion it from future losses.
• 3M: The company slashed its dividend after spinning off Solventum, its healthcare business. It adjusted its dividend payout ratio to 40% of adjusted free cash flow—a move that was expected by many experts.

Are Dividend Stocks Worth It?

This depends on your investment goals and financial situation. But, many investors like having dividend stocks in their portfolio. These companies offer a steady source of income and can help offset some of the risks associated with other investments in your portfolio.

What Is a Dividend Yield?

The term dividend yield refers to the dividend paid by a company expressed as a percentage of its share price. Put simply, it’s a financial metric that indicates a company’s dividend payout relative to its stock price. A company’s dividend yield is calculated by dividing the total annual dividends per share by the current share price.

What Is an Ex-Dividend Date?

An ex-dividend date is the date at which a shareholder becomes eligible to receive dividends. In simple terms, it is the cutoff date for dividend eligibility. This is typically one business day before the record date. Shareholders who purchase the stock before the ex-dividend date become eligible to receive the dividend. Those who begin investing in the stock on or after the date must wait until the next period to receive dividends.

The Bottom Line

Companies that can grow their dividends are seen as stable and attract investors looking for income as well as capital gains. Sometimes, however, it can hurt a company’s bottom line to distribute profits as dividends rather than retain earnings to solidify the company’s financials. Companies may cut dividends in response to an economic downturn, a spate of negative earnings, or more serious threats to the company’s health. Other times, the cut may be more strategic and orient towards future growth or allow for buybacks.