Discussion Papers in Accounting and Finance Dividend Cuts, Firm Profitability & Financial Characteristics

3 ABSTRACT This paper investigates the dividend decisions of firms in the UK reporting losses after sustained periods of profitability. It is found that loss-making firms are more likely to reduce dividends compared to firms that remain profitable, although a loss is far from a guarantee that the dividend payment will be reduced. A lower propensity to reduce dividends is found in the UK relative to the US, consistent with the stronger culture of dividend payments. The size of the loss is an important factor in a firm's dividend policy. However, this is mitigated to some extent if it is the result of unusual accounting items because managers view these as a temporary fluctuation in profitability. Leverage is found to have some role in the dividend decision, with higher levels of debt consistent with a greater likelihood of a reduction in the distribution whilst also suppressing profitability in future years. Profit margins prior to the loss year are also a significant factor in dividend policy whereby low margin firms are more likely to cut dividends. 4 Despite being the two most heavily researched stock markets in the world, the US and UK have notable differences in dividend cultures, with the former having lower average dividend yields 1 and a higher proportion of non-dividend paying stocks. Recent studies by Fama and French (2001) and Benito and Young (2001) have documented a decline in dividend payers in both the US and the UK respectively. Furthermore, they describe the characteristics of dividend payers and non-payers, both former payers and firms that have never paid a dividend. Benito and Young (2001) take the additional step of considering the differences between firms that cut dividends and firms that omit dividend payments. We further extend this comparison by examining the dividend decisions of companies that have a considerable history of both profitability and dividend payments, but that then incur a downturn in earnings or a loss. Of particular interest is the dividend decision made by firms in the initial loss period. Are managers reluctant to cut dividends, viewing the loss as a temporary phenomenon, or do they act decisively by reducing the dividend to preserve the firm's cash resources? DeAngelo et al (1992) used US data for 1980-85 to investigate the dividend policy of firms that reported a poor earnings performance after sustained dividend distributions and profitability. They cite work by Miller and Modigliani (1961), arguing …