© 2000 John Petroff
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© 2000 John Petroff |
3)- Instability of retained earnings
Because of the fixed deductions from earnings described above, the residual left for retained earnings is most unstable. In fact, in years of insufficient earnings, dividends are paid out of accumulated retained earnings (as, for instance, apparent in Timken's example in the previous section). Such dividends, usually maintained exactly at the previous year level, are necessary for management to tell shareholders that it is confident in the future of the company. A reduction in dividends, even a very small one, would convey a message that future earnings will not be large: that will cause the stock price to slide down a little. Should the corporation not pay any dividend one year, the stock price slide would become a free fall. Thus, dividends must be maintained, no matter how unstable retained earnings become.
Retained earnings can be expected to be closely correlated with business cycles for most corporations. In pro-cyclical industries such as manufacturing of durables, firms must anticipate even more instability in retained earnings, and must guard against it by keeping the payout rate low and avoiding large fixed charges: as seen in the previous chapter, their proportion of equity in total assets must be large.
See review questions Q-12A3.1 and Q-12A3.4.
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