What Is a Residual Dividend?
Let me explain what a residual dividend is. It's a dividend policy that companies use where the dividends paid to you as a shareholder come from whatever profits are left after the company covers its capital expenditures, or CapEx, and working capital costs.
If a company follows this policy, they fund their CapEx with available earnings first, and only then do they pay dividends. This means the amount you receive as dividends can vary each year, depending on those leftovers.
Key Takeaways on Residual Dividends
Companies adopt residual dividend policies to put capital expenditures ahead of immediate dividend payments to shareholders like you. They invest profits in growth opportunities before distributing what's left as dividends.
Management chooses this to fuel the company's development, such as upgrading manufacturing or reducing waste, which should lead to better long-term growth. But with reduced and fluctuating dividends, they often need to explain their choices to keep shareholders on board.
This policy rests on the idea that you, as an investor, don't prefer immediate dividends over long-term capital gains.
How a Residual Dividend Works
In a residual dividend policy, companies use their earnings to cover CapEx first. Whatever earnings remain after that go to dividends.
A company's capital structure usually includes long-term debt and equity. They might finance CapEx with loans or by issuing more stock.
To gauge how well this policy is working, look at return on assets (ROA), which is net income divided by total assets. It's a key metric for assessing management's decisions.
Special Considerations
Shareholders might go along with using earnings for CapEx, but the investment world watches closely to see if that spending generates more income. That's where ROA comes in—net income over total assets—to measure management's performance.
Take a clothing manufacturer spending $100,000 on CapEx: if it's a smart move, they boost production or cut costs, increasing profits and improving ROA. This makes shareholders more likely to accept the policy going forward.
But if earnings drop while CapEx stays high, your dividends will shrink.
Requirements for a Residual Dividend
When a business makes earnings, they can retain them for operations or asset purchases, or pay them out as dividends to stockholders like you. Every company needs assets to run, and those assets wear out and need upgrades or replacements. Managers have to balance operating needs with rewarding shareholders.
For this policy to hold up, it assumes the dividend irrelevance theory is correct—that you as an investor don't care if returns come as dividends or capital gains. Under this, the policy doesn't change the company's market value since both forms are valued the same.
The residual dividend calculation happens passively; companies financing CapEx with retained earnings often end up with this policy, leading to inconsistent and unpredictable dividends for you.
Example of Residual Dividends
Consider a clothing manufacturer with upcoming capital expenditures. This month, they need $100,000 to upgrade machinery and buy new equipment.
They generate $140,000 in earnings and spend $100,000 on CapEx, leaving $40,000 to pay as a residual dividend. That's $20,000 less than the last three months.
Shareholders might not like the cut, so management has to explain the capital spending rationale to justify it.
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