WORKING CAPITAL MANAGEMENT

1. What is working capital management?

It is the company’s managerial accounting strategy designed to monitor the utilization of the
current assets and current liabilities to ensure the most financially efficient operation of the
corporation.

It is the management of the firm’s current assets, such as: cash balance, marketable securities,
inventory, and accounts receivable, and current liabilities such as: accounts payable and accruals.
Thus, if the firm cannot maintain a satisfactory level of working capital, it is likely to become
insolvent and consequently bankrupt.

a). Essential terms in working capital management

• Gross working capital: This is the total of all current assets (some authors often regard total
current assets as the working capital because they can be used and replaced, and more
importantly, they are considered liquid because they can be converted into cash in a relatively
short time.
• Net working capital: Is defined as the difference between the current assets (CA) and the
current liabilities (CL), and can be presented as:
Thus: Net Working Capital (NWC) = CA – CL
• Current ratio: calculated as current assets divided by current liabilities. This metric is
intended to measure a firm’s liquidity.

Sample current assets and liabilities as indicated in table 1 below

Table 1: (in Thousands)

b). Importance of Working Capital Management

The importance of working capital management as a day-to-day activity is reflected in the fact that
financial managers spend a great deal of time managing current assets and current liabilities. These
involved arranging short-term financing, negotiating favorable credit terms, controlling the
movement of cash, administering accounts receivable, monitoring the investment in inventories,
and investing in short-term surpluses. These are all aimed at:
• Achieve higher return on capital
• Improve the credit profile & solvency of the business entity.
• Improve profitability
• Enhance liquidity
• Competitive advantage in the business environment
• Give a good basis for suitable financing terms.
• Enhance greater cash inflow than cash outflow
• Be able to absorb market dynamics (demand and shocks situations),
• Improve the timing of cash inflows into the company.

2. Working Capital Policy

The working capital policy of a company refers to the level of investment in current assets for
attaining their targeted sales. Working capital policy involves decisions regarding two basic
questions:
• What is the appropriate level of investment in current assets?
• How should current assets be financed? - Short-term funds, long-term funds, or some
mixture of the two.

Working Capital Management involves investing in current assets and financing current assets:

a) Current Asset Investment Policy

There are three policy alternatives: relaxed, restricted, and moderate

i. Relaxed current assets investment policy: A policy under which relatively large amounts
of cash and marketable securities and inventories are carried. As a result:
• Sales are stimulated by a liberal credit policy that results in a high level of receivables
• Operating problems or risks are minimized because obligations are met promptly.
• There is a risk of bad debt or default
• It may translate to a lower rate of turnover
• Cash and marketable securities typically yield a lower return on equity (ROE)
• Additional financing costs may be incurred thereby lowering ROE

ii. Restricted current assets investment policy: This is a policy in which a firm has a tight
investment policy. It also means that a firm’s holdings of current assets are minimized. Lower
levels of current assets result in the opposite effects of the restricted (lean and mean) policy above.

iii. The moderate current assets investment policy: A policy that lies between the relaxed and
restricted current asset investment policies. In other words, the moderate policy lies between two
extremes in terms of both expected risk and return.

The optimal strategy is the one that maximizes the firm’s long-run earnings and the stock’s value.
In trying to achieve this optimality, financial managers must consider the level of changing
technology in the particular industry.
This is because changing technologies can lead to changes in the optimal policy.
b) Current Asset Financing Policy
Investments in current assets must be financed; and the primary sources of funds include short
(current) and long-term liabilities like bank loans, credit from suppliers (accounts payable),
accrued liabilities, long-term debt, and common equity. Each of these sources has advantages and
disadvantages, so each firm must decide which sources are best for it.

However, most businesses experience seasonal fluctuations, cyclical fluctuations or both. For
example, construction companies have peak business in spring and summer while retailers have
peak businesses during public holidays and religious holidays and manufacturers supplying both
the construction and retail companies follow similar patterns. Similarly, all businesses must build
up current assets when the economy is vibrant, and then sell off inventories and have net reduction
of accounts receivable when the economy slacks off. The three current assets financing approaches
are as follows:
• Maturity matching or Self-liquidating) approach: This is a financing policy approach that
calls for matching of current asset and liability maturities. This strategy minimizes the risk that
the firm will be unable to pay off its maturing obligations if the liquidations of the assets can
be controlled to occur on or before the date the obligations reach maturity. For instance, the
inventories, which are to be sold off in 30 days, could be financed with a 30-day bank loan.
However, the two difficulties in matching maturities are:
o Uncertainty about sales and the lives of the firm’s assets.
o It is also because some common equity, which has no maturity, must be used to finance
the firm.
• Conservative approach: This involves the use of long-term debt and equity to finance all
long-term fixed assets and permanent current assets (the level of inventory, cash, and accounts
receivable, which tends to be maintained) The essence of this approach is the attempts to
eliminate the use short-term financing even though it is often difficult to accomplish. However,
in the approach, firms only use some amount of short-term credit to meet financing needs
during peak season periods.
• Aggressive approach: A firm that follows the aggressive approach finances all of its fixed
assets and some of its permanent current assets with long-term capital; the remainder of the
permanent current assets and all of the temporary current assets are financed with short-term
financing, such as bank loans. However, the aggressive approach is riskier than either of the
two approaches because the short-term credit used to finance the permanent current assets must
be renewed each time it becomes due. This has the consequences of interest rate risk and risk
of loan renewal problems.

Generally, even though the short-term financing has the advantages of speed, flexibility and lower
cost, it also has some disadvantages of high interest rate risk and possibility of taking excessive
loans that could cripple the objectives of the business.

3. Cash Conversion Circle (CCC)

CCC is a metric that expresses the length of time, in days, that it takes for a company to convert
the resources tied up in production into cash. It focuses on the length of time between when the
company makes cash payments, or invests in the manufacturing of inventory (products), and when
it receives cash inflows or realizes a cash return from its investment in the production.
 a) Production or Inventory cycle: this measures the length of time it takes to convert raw
materials into finished goods, and deliver an order from a customer, usually measured in days
or sell those goods. It is also the amount of time that the products remain as inventory in
various stages of completion.

The inventory cycle is calculated as:

Inventory cycle = Inventory / Cost of goods sold per day =

Inventory / (Annual cost of goods sold / 365 days) = xdays

b) Collection or receivables cycle: this meausres the length of time it takes for a business to
receive money from its clients/customers/receivables i.e. to convert the firm’s receivables into
cash:
The receivable cycle is calculated as:

Receivable’s cycle = Receivables / Average daily credit sales =

Receivables / (Annual credit sales / 365days) = ydays

c) Payment or Payables cycle: this meausres the length of time from when the company purchases
raw materials and when it pays for the purchaseincluding the payment for labor.

The payment cycle is calculated as:

Payables cycle = Payables / Cost of goods sold per day =

Payables / (Annual cost of goods sold / 365 days)

“working capital cycle” The three stages are also referred to as “working capital cycle” in which
they purchase or produce inventory, hold it for sometimes, and then sell it and receive cash.

Thus, Cash Conversion Cycle (CCC) formular or equation is given as:

CCC = (Inventory / production cycle + Receivable / collection cycle) – Payment / Payables cycle
Solution
a) Calculating the CCC of Hana Investors
CCC = (Inventory cycle + Receivable cycle) – Payable cycle

• Determine the Inventory cycle = Inventory / Cost of goods sold per day
= Inventory/(Cost of goods sold/365)
= N250,000/(N1,013,889/365)
= N250,000/N2,777.78
= 89.99 approx. = 90 days
Thus, it takes Hana Investors an average of 90 days to sell its merchandise, not the 60 days as in
the business plan.

• Determine the Receivables or collection cycle (or days sales outstanding) as:
= Receivables/Sales per day
= Receivables/(Annual Sales/365)
= N300,000/(N1,216,666/365)
= N300,000/3,333.33
= 90days
This also means, it takes the management of Hana Investors 90 days after a credit sale to receive
cash, not the 60 days called for in the business plan.

• Calculate the payables deferral period or payable cycle = Payables/Cost of goods sold per day
= Payables/ (Cost of goods/365)
= N150,000/(N1,013889)/365)
= N150,000/2,777.78 = 53.99 days
 = 54 days
Initially, the firms’ financial plan was to pay its suppliers after 40 days; but from the operational
results, it shows that Hana Investors is a slow payer, delaying payment until Day 54 days

Therefore, CCC = (Inventory cycle + Recevables cycle) – Payables cycle

= (90 days + 90 days) – 54 days
CCC = 126 days
From our calculation, we have seen that Hana Investors actual 126-days CCC is quite different
from the planned 80 days. This implies that, it takes longer than the planned to sell merchandise;
customers don’t pay as fast as they should, and the company pays its suppliers slower than it
should. The end result is a CCC of 126 days versus the planned 80 days. This means when the
planned 80-day CCC is “reasonable,” the actual 126 days is too high.

b) The advice to Hana Investors is as follows:

• The company should push sales staff to speed up sales and the credit manager to accelerate
collections.
• It is also advisable to review sales credit terms but such review has to be cautiously managed
so as not to lose customers.
• The purchasing department should try to get longer payment terms. This is because, if the
company could take these steps without hurting sales and operating costs, it would help to
improve the firms’ profits and stock price.
Generally, the firm’s goal should be to shorten its cash conversion cycle as much as possible
without hurting its operations. This effort would improve profits because the longer the cash
conversion cycle, the greater the likelihood for external financing through loans which also has its
cost. In other words, the CCC essentially measures how quickly a company can convert its
products or services into cash.

NOTE: In calculating cash conversion cycle (CCC), some companies tend to use averages instead
of annual values. For instance, average inventory can be determined by adding opening and closing
stock and divide by two. The same principle is applied for receivables and payables. In both cases,
the outcome, will be the same provided consistency is maintained.

3. Management of working capital components

• Cash management
o Determining cash balance
o Calculating the optimal cash balance
• Marketable securities management
• Credit management
• Inventory management

a) Cash management
This is about the company having sufficient cash to support its operations without holding an
excessive amount of cash. Some of the reasons for this include:
• Requirements for the day-to-day operation. It is also necessary because the cash balance is
associated with routine payments and receipts or collection. For instance, payments must
 be made in cash and receipts are deposited in a cash account. This reason is also referred
to transactions balance
• To fulfill one of the requirements of banks. Banks often require firms to maintain certain
compensating balance on deposit to help offset the costs of providing services such as
check clearing, cash management advise, and so forth.
• Cash inflows and outflows are somewhat unpredictable. Firms generally hold some cash
in reserve to ensure against random, unforeseen fluctuations in cash flows and also serve
as precautionary balances. Therefore, the less predictable the firm’s cash flows, the larger
such balances should be.
• Cash balances are held to enable the firm take advantage of bargain purchases that might
arise. These funds are called speculative balances, especially in firms under certain market
conditions or behavior.
• To preserve its credit rating in line with those of other firms in the same industry. A strong
credit rating enables the firm to purchase goods from suppliers on favorable terms and to
maintain an ample line of credit with its banks.

i). Determining the cash balance:

The fundamental problem financial managers need to address is how much should be allowed as
minimum and maximum cash balance:
• The minimum cash balance: The size of a firm’s minimum cash balance often depends
on three factors, such as:
o The ability of the management to raise cash quickly when needed,
o The ability to forecast or predict cash needs, and
o The amount required for emergencies
• The maximum cash balance: In other words, how much should be allowed to accumulate
in the cash account before the excess is withdrawn and invested in something that produces
a return? This depends on three factors:
o Availability of investment opportunities
o Expected return in investments
o Transaction costs involved in making the investment.

ii). Calculating the optimal cash balance

Here is the mathematical models to help firms find an optimal ‘target’ cash balance between
minimum and maximum limits.

The Miller-Orr Model Cash Management Model

This is a model of the demand for money by firms.
This is a cash management model that solves for an optimal target cash balance about which the
cash fluctuates until it reaches an upper or lower limit. In this case, if the upper limit is reached,
investment securities are bought, bringing the cash balance down to the target again. But if the
lower limit is reached, investment securities are sold, bringing the cash balance up to the target.

Based on their model, Miller Orr provided how to achieve the Target Cash Balance (Z) as:
Where: TC = Transaction cost of buying or selling short-term investment securities
V = Variance of net daily cash flows
r = Daily rate of return on short-term investment securities
L = Lower limit to be maintained in the cash account
However, Miller-Orr also developed an equation to calculate the upper limit for the cash balance
as follows:
H = 3Z - 2L
Where H = Upper limit for the target cash balance
Z = Obtained target cash balance
L = Lower limit to be maintained in the cash account.
EXAMPLE 2: Assume that Nile Investors short-term investment securities are yielding 4%
percent per year and that it costs the Investors $30 each time it buys or sells investment securities.
Now, assume that the firm’s cash inflows and outflows occur irregularly and that the variance of
the daily net cash flows has been found to be $90,846. If the management wants to keep at least
$10,000 in the cash account for emergencies, you are required to:
a). Calculate Nile Investors’ target cash balance, and;
b). Determine the upper limit for the target cash balance.

Solution:
Calculating the target cash balance Based on Miller-Orr Model,
The target cash balance =

Where: TC = Transaction costs = $30

V = variance of the daily net cash flows = $90,846
r = 4% per year or 0.04/365 per day =
L = Lower limit to be maintained in the cash account = $10,000
u . Hence, the target cash balance Z will be obtained as:
 • Also, in calculating the upper limit of the cash balance, we determine as follows:
H = 3Z -2L
Since Z = $12,652
L = $10,000
H = (3 x $12,652) – (2 x $10,000)
H = ($37,956 - $20,000)
The upper limit = H = $17,956
This suggests that:
• if the cash balance increases to $17,956, Nile investors will buy $5,304 - being the
difference between the upper limit of $17,956 minus the target balance of $12,652
• Similarly, if the cash balance falls to $10,000, then, Nile investors will sell $2,652 worth
of investment securities to raise the cash balance to $12,652
• It therefore informative that, financial managers must frequently provide detailed estimates
of their firms future cash need, and the best technique to use is to develop a cash budget to
show where cash is expected to come from and where it is expected to go during a given
period.

b). Marketable Securities Management

In practice, the management of cash and marketable securities cannot be separated, because
management of one implies management of the other, since the amount of marketable securities
held by a firm depends on its short-term cash needs. Although marketable securities provide much
lower yields than operating assets, nearly every large firm has them because:
• Marketable securities serve as a substitute for cash balances. Firms often hold portfolios of
marketable securities (treasury securities, bankers’ acceptance, preferred stocks,
commercial papers, etc.) liquidating part of the portfolio to increase cash account when
cash is needed.
 • They serve as temporary investments – to finance seasonal operations or, to amass funds
to meet financial requirements in the near future.

Despite, the importance of holding marketable securities, financial managers should always
consider some factors that often affect their choice. These include:
• default risk to the contractual obligation of principal and interest,
• interest rate risk,
• inflation rate risk, and;
• the tax risk that affects the yield return.

c). Credit Management

Most firms therefore sell for credit, and the primary reason is because their competitors often offer
credit. This situation therefore suggests the need for effective credit management, because too
much credit is very costly in terms of the investment in, and maintenance of, accounts receivables.
Conversely, too little credit might result in the loss of profitable sales.

To maximize a firm’s profitability, a financial manager needs to understand how to effectively

manage the firm’s credit activities. This can be achieved by determining the appropriate:
• Credit policy for the firm, based on terms of credit, collection policy, and credit standards
(that is, how to qualify for a credit sale)
• Procedures for monitoring the credit policy - determining how long.
• Ways to evaluate or analyze credit policy changes in response to market and
competitiveness.

d). Inventory Management

Inventory is one of the most important business assets because it generates revenue. There are two
fundamental reasons why most companies maintain inventory in some form. These reasons are:
• demand cannot be predicted with certainty,
• it takes time to get a product ready for sale. Although excessive inventories can be costly
to the firm, so are insufficient inventories. That means, customers might purchase from
competitors if products are not available when demanded, thus leading to a loss of future
business. Many aspects of inventory management models are designed to minimize the
costs that are associated with inventory or its production. These models include:
Ø The economic order quantity (EOQ) method,
Ø The just in time, and
Ø The basics of redundant inventory (A redundant inventory item is an item that a company does
not use in its current operations but it serves as a backup role just in case the current item fails
during operations).

2. Theories of Working Capital Management (WCM)

WCM theories are those about the management of short-term assets as well as liabilities. They
also provide enlightenment on the optimum level of liquidity that ought to be maintained by firms
to enhance profitability. These theories include the following:
• Trade-off Theory: This theory encourages companies to trade off the risks of high and low
(positive and negative) working capital by striking a balance between profitability, liquidity,
and solvency.
o A high working capital investment may lead to a high cost of holding inventories and
an increased risk of bad debt which would affect profitability.
o On the contrary, a low level of working capital might trigger a loss of sales due to
inadequate supplies as well as diminishing the competitive edge as customers might
switch to other traders.

• Pecking Order Theory (POT): The pecking order theory states that companies prioritize their
sources of financing (from internal financing to equity) and consider equity financing as a last
resort. Internal funds are used first, and when they are depleted, debt is issued. When it is not
prudent to issue more debt, equity is issued. This theory maintains that businesses adhere to a
hierarchy of financing sources and prefer internal financing when available, and debt is
preferred over equity if external financing is required.

• Agency Theory: Agency theory is an economic theory that views the firm as a set of contracts
among self-interested individuals. An agency relationship is created when a person (the
principal) authorizes another person (the agent) to act on his or her behalf. It aims to address
the possible conflicts between the principal and the agent. There are three possible types of
conflict, between shareholders and managers/directors; shareholders and the firm’s creditors,
and expropriation issues arising between minority and large shareholders.

• Liquidity Preference Theory: The liquidity preference theory, developed by John Maynard
Keynes, holds the premise that people naturally prefer holding assets in liquid form—that is,
in a manner that it can be quickly converted into cash at little cost. The most liquid asset is
money. It also aims to explain how interest rates are determined.

• Price Discrimination Theory: Trade credit has been identified as an effective instrument for
price discrimination. Price discrimination is a selling strategy that charges customers different
prices for the same product or service based on what the seller thinks they can get the customer
to agree to.

• Free Cash Flow Theory: Free cash flow theory explains that manager may propose to retain
a certain level of cash in order to reinforce their control on the asset’s composition. However,
holding excessive cash may lead to misappropriation and the excess funds may be applied by
managers to projects that benefit them personally (like increasing their remuneration and
power). On the other hand, larger firms are prone to maintain a lower level of cash flow because
of their affiliated relationship with financial institutions and strong investors.

• Transactions Costs Theories: Ferris (1981) has clarified that trade credit might play its role
in diminishing transaction costs incurred when making payments to suppliers if a large volume
of purchases are accumulated or combined in one transaction. This is because there is the
uncertainty of both when the cash is needed and the frequency of payments demanded;
• Cash conversion cycle theory: Richards and Laughlin developed the cash conversion cycle
theory in 1980, which shows that a curtailed cash conversion cycle for a company is optimal
for better financial performance. The cash conversion cycle theory describes the period taken
to complete a sequence of events from purchasing raw materials or goods to completing cash
sales.

• Cash management theory: Cash management primarily means managing cash to meet your
daily obligations. This theory asserts that cash in its utmost liquid style is a non-productive
asset. Disposable cash does not earn interest but all the same, the business needs to maintain
an ideal cash balance, as excess cash means loss of interest and insufficient cash hinders the
development of the company's operating activities. Insufficient cash flow will also mean that
the company will not be apt to meet its short-term financial commitments when they fall due.

• Accounts receivable management theory: This theory relate to the rise in access to credit in
many organizations has brought about an increase in the amount of debt by consumers, which
has had a major effect on the profits made by several companies. Accounts receivable
management is a problem for all institutions that extend credit to their customers, and the
demand for organizations is to conserve their profit margins by minimizing stakes, lowering
collection costs, and maximizing cash collections.
• Operating cycle theory: An operating cycle refers to the time it takes a company to buy goods,
sell them and receive cash from the sale of said goods. In other words, it's how long it takes a
company to turn its inventories into cash.
• Resource-based theory: The resource-based view of a firm emphasizes the portability of a
firm's resource capabilities as an important determinant of its ability to provide a sustainable
competitive advantage. In this case, resources are the basis of business survival and
profitability. These can be human or material resources.
• Risk and return theory (also, an aspect of Portfolio theory): The risk and return theory is
an essential aspect of portfolio theory and is the strength of the firm or financial manager in
determining the portfolio of assets or the portfolio to acquire and thus the decisions regarding
the formation are based on the working capital elements necessary to obtain them in risk and
return theory. Investing in the stock market is both profitable and risky. The return can be in
the form of a return or a capital appreciation. The risk is the uncertainty of a future outcome.
The return that will be created in a future period is called the expected return. Actual
performance during the past period is called achieved performance. The return on the asset
may differ from the expected return.
___________________________________________________________________________

OVERVIEW OF COMMON STOCK AND DIVIDEND POLICY

1. Review on the types of common stock

Investing in common stock is about taking educated risk, and about receiving returns. Types of
stock, which can be classified as follows:
• Blue Chip Stocks: A blue-chip stock is a company that typically has a large market
capitalization, a sterling reputation, excellent financials, and many years of success in the
business world. Blue chip stocks are high-grade investment or companies which have long and
unbroken records of earnings and dividend payments.
• Growth Stocks: Many of the blue chips may also be considered growth stocks. Growth stocks
are stocks that offer a substantially higher growth rate as opposed to the mean growth rate
prevailing in the market. It means that a growth stock grows at a faster rate than the average
stock in the market and consequently, generates earnings more rapidly
• Income Stocks: Income stocks are stocks that offer regular and steady income, usually in the
form of dividends, over a period of time with low exposure to risk. They are often sought by
trust funds, pension funds, university and college endowment funds, and charitable educational
and health foundations. There are also some stocks which may be classified as income stocks
because they pay a higher-than-average return.

Cyclical Stocks: Cyclical stocks are known for following the cycles of an economy through
expansion, peak, recession, and recovery. Most cyclical stocks involve companies that sell
consumer discretionary items that consumers buy more during a booming economy but they spend
less on them during a recession. When conditions deteriorate, business for the cyclical company
falls off sharply, and profits diminish greatly. Industries which may be regarded as cyclical include
steel, cement, paper, machinery and machine tools, airlines, railroads and railroad equipment, and
automobiles.
• Defensive Stocks: A defensive stock is a stock that provides consistent dividends and stable
earnings regardless of the state of the overall stock market. There is a constant demand for
their products, so defensive stocks tend to be more stable during the various phases of the
business cycle. Utility stocks (electric and gas utilities, the shares of gold mining) and
companies whose products suffer relatively little in recession periods. These include shares in
companies producing tobacco, snuff, soft drinks, candy bars, and other staples.
• Speculative Stock: Speculation can be defined as a transaction or business that leaves its profit
to chance and luck. A speculative stock is a company that is characterized by extreme risk with
the possibility of extreme returns in compensation for that risk. These stocks are typically
traded on the over-the-counter (OTC) markets instead of the formal exchanges Examples of
speculative stocks are the high-flying glamour stocks, hot new issues, and penny mining
stocks.

2. Concepts of dividend?
• The cash payments that corporations make to their stockholders. In other words, they are
the returns the common stockholders receive from a firm for the equity capital they have
supplied
• It is the cash rewards on the stock investment based on the total value of holdings at any
given period.
• It is the obligation of the firm to investors in the form of periodic cash payments depending
on the investors’ value of shares or equity holding.

3. Measurement of dividend

The conceptualization and understanding of dividends relate to the nature of a company’s dividend
policy in relation to its pay-out ratios. Some of them include:
 • Retention ratio: This is a percentage of a firm’s net income that is reinvested into the firm
as retained earnings – This can be calculated as Retained earnings/net income or it can
be obtained as: (Net income - dividend distributed)/Net income.

• Dividend pay-out ratio: This is a comparison of the total amount of dividends a firm pays
out over a specified period.

o This is calculated as: Dividend payout ratio = Dividend paid/net income

For instance, If Nile incorporation earns a net income of N20,000 and pays N3,000 in
dividends, then its dividend payout ratio can be calculated as: N3,000/N20,000 = 0.15 =
15%
o It can also be calculated by taking out the ratio of earnings retained by the firm from
the total earnings during a period as follows: 1- retention ratio.

• Dividend yield: this is the amount of cash dividends paid to shareholders relative to the
company’s share price. This is calculated as: annual dividends per share/current
company share price

• Price equity ratio: This is the market value of a company’s shares compared to its income.
It is calculated as: share price/earnings per share

• Price earnings ratio: This describe the market price of a company shares divided by the
company’s earnings per share, and is obtained as: Share price/EPS

• Earnings yield: This describes the company’s earnings per share for the last 12 months
relative to its current share price. The yield is obtained by dividing – the earnings per share
for 12 months divided by the current share price.

Note that: The board sets the amount per share that will be paid and decides when the payment
will occur. The date on which the board authorizes the dividend is the declaration date. After the
board declares the dividend, the firm is legally obligated to make the payment of the dividend to
all shareholders of record on the specific date set by the board, called the record date.

4. Types of dividends:
There are many forms of dividends and with different names, but there are four common types
which can be classified into:
• Regular cash dividends: A dividend that a company pays out routinely to shareholders,
often quarterly and the same from quarter to quarter
• Special or extra cash dividends: This is a dividend that a company does not guarantee in
the following period. Here, the term special or extra dividend, the board of directors of a
firm implies that the dividend is a one-time, nonrecurring payment. In many cases, this
type of dividend is usually associated with periods of unusually strong company
performance.
 • Stock Dividends: This is a type of dividend in the form of shares of stock instead of cash.
For example: A 10% stock dividend means that the investor will receive a new share of
common stock for every ten shares that are currently held.
• Liquidating Dividends: Shareholders receive a liquidating dividend when the company is
discontinuing operations or when it has sold off a major portion of the business.
o When a firm ceases operations, it pays off all debts, and the remaining funds belong
to the shareholders
o For individual shareholders, liquidating dividends can also be the selling price
because that is the day the owner liquidates his or her holdings of the company.

5. Concepts of dividend policy

• Is a firm’s strategic choice or decision to pay out earnings to stockholders at an appropriate
time or to retain them for internal purposes of the firm.
• It deals with whether the firm should pay out a large amount now or invest more in the
company.
• It is a systematic allocation of a designated portion of a company’s income to its
shareholders
• It dictates how much and how often a company will pay dividends to its shareholders.

a). Importance of a dividend policy

• It helps market participants (both current and potential stockholders) on the certainty of
their investment. This is to avoid surprises and inconsistencies on expected returns.
• To ensure stable stock prices. In this case, when stockholders are not certain on getting
what they expect, they often show their displeasure by selling off their stock, and thereby
reducing the stocking price