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, I will not be insisting the management to raise the the payout ratio because it can be seen that the company has not improved its average collection period because the average collection period has not been affected even after there has been an increase in the sales growth and higher net profit margin so there should be high focus upon high liquidity and when there would be a constant average collection period, it will mean that the company is not able to collect its receivables quickly so the company should be trying to collect its receivable quickly in order to improve its overall cash collection cycle which will be improving the overall equity in the hands of the company and it will also mean that the company will be having a lower cash in its hands due to constant average collection period which should have been reduced because of increase of sales and profit margins.

Hence, I will be advising the company in order to save its profits and improve its liquidity in the long run because the company does not have enough liquidity even if it has increased its sales and profit margin so the company should be trying to increase its overall liquidity by not providing higher Dividend to the shareholders and hence I will be advising the company in order to maintain a higher liquidity by not providing with higher payout ratio.

Hence, it can be said that higher payout ratio will soak out the liquidity out of hands of the company and it will not be able to increase with its sales growth and hence the company should be rather reinvesting the profit in order to increase its sales more rather than distributing the dividend.