A growing company generally gets working capital from two different sources: the cash flow that the business generates and additional capital from external financing sources. When a company pays dividends, it diverts some of the cash flow that it generates back to shareholders, increasing its required external financing. Below, we'll go into some of the details in coming up with required external financing.
The general idea behind required external financing
When a company seeks to boost its revenue, it typically needs to assess the short-term impact on its financials from growth initiatives. In general, additional funds will be needed to achieve growth. In simplest terms, the amount of external funds needed will be equal to the expected increase in assets at the higher sales level, reduced by the immediate increase in liabilities stemming from the initiative, and further reduced by any increase in retained earnings.
The increase in retained earnings is dependent on how the company handles its dividend payments in response to growth. Many companies look to target a specific payout ratio, maintaining the proportion of its profits that the company chooses to pay out in the form of dividends. Therefore, as revenue and profits grow, so too does the company's total amount of dividend payments.
However, if a company keeps its overall dividend flat even as profits rise, then less external financing will be needed. The extra retained earnings will reduce the amount necessary to achieve growth, but with the trade-off that investors will receive a lower payout ratio.
A simple example
Consider a business that has revenue of $1,000, profits of $100 and pays a $50 dividend. The company's assets amount to $2,000, and liabilities are $1,500 with $500 coming from current accounts payable. The business wants to grow sales by 20%.
Based on its current asset utilization, assets would have to grow from $2,000 to $2,400 to generate the extra 20% in sales, requiring $400. Subtract from that the increase in immediate liabilities, which would include only the accounts payable line and move it from $500 to $600, or a change of $100. Finally, given the company's profit margin of 10% and payout ratio of 50%, the 20% boost in sales would result in profits rising to $120, of which $60 would get paid out to shareholders as dividends. That would leave retained earnings rising by $60. Therefore, the required external financing would be $400-$100-$60, or $240.
However, this assumes that the company would raise its overall dividend from $50 to $60. If it left the dividend payout unchanged, then it would see retained earnings rise by $70, and that would reduce the required external financing to $230.
Growing businesses need capital, and there are limits to what a company can get from its internal operations. By being aware of needs for external capital, a business can assess which growth opportunities are realistic.
Now that you're learning more about stocks, you may want to start investing today. Check out The Motley Fool's Broker Center to find the best broker for you.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!