Question

Financial modeling question. One of the clients is a large manufacturing firm. The firm is expected a strong level of sales growth which will lead to a higher net profit margin and will require an increase in new warehouses and new distribution centers. The firm's average collection period (ACP) will not be affected.

The manufacturing firm's CEO comments. "Due to higher expected profitability, our shareholders will likely expect a larger dividend. Therefore, we should increase our payout ratio."

Would this be a good recommendation to the firm to increase its payout ratio? Explain.

Answer 1

No, increasing the payout ratio will mean that the company will have to pay the higher amount of dividend to its shareholders and that should not be rational decision because it can be seen that the company has not improved its average collection period and the company will not be having adequate amount of liquidity on its hands if it starts to increase the overall payout ratio, so the profits which have been made in excess by the company will not be retained by the company and it will be having a lower amount of Liquidity on its hands when it will be paying with the higher dividend and it can lead to increase in risk associated with the liquidity in the short run.

In this case, the company has increased its profits as well as it has also increased its net profit margin so when there is an increase in the overall revenues and net profit margin, the average collection period should also have been increased due to higher amount of profits and increasing profit margins but the company has not been able to increase its average collection period because the company does not have a sound cash collection and it has not been able to improve upon its cash collection period so the company does not have enough liquidity on its hands and hence it will be better to reinvest the profits back into the business because the company is also making higher profits and company is maximizing upon its sales so it would be better to increase the growth rate of the company by investing the profits back into the business and hence it can be said that the company should be trying to not distribute excess of the profits made as dividend but rather it should be trying to reinvest it into the business in order to grow more and it can also transfer it to reserve in order to have optimum liquidity on its hands because the company does not have a better average collection period.