It was a real pleasure meeting a large number of ACCA tutors at the recent Manchester conference. One issue did come up which reflected the separation between the world of accountants and the world of business finance. I was roundly taken to task by one participant for defining dividend capacity in free cash flow terms. The individual concerned thought this was an 'error' - more on errors later - and was not too amused when I suggested that maybe it was him who had got it wrong. The point he argued is that dividend capacity is an issue of available profit and that there are laws which limit the amount of dividend that can be paid. Indeed there are, companies by and large are not allowed to make distributions in excess of their distributable reserves. Too true but for the vast majority of companies this will exceed their capacity to distribute by a substantial margin.
I think the key point here is that distribution has to be limited to the economic income of the business (i.e., the change in its economic value in a given period) after making appropriate capital maintenance adjustments. Or, to put it into more acceptable terms - their ongoing dividend capacity is limited to that cash distribution which leaves the operating capacity of the business unimpaired. Now many accountants (may the force be with them because I too am a member of the tribe) have a touching belief that published earnings sets the limit on what can be paid out. Sadly no. Let's make the obvious points (i) dividends are not distributions of profit they are distributions of cash and (ii) even under IFRS dividends are not shown as a distribution from profit but a reduction in capital in the balance sheet. But the more telling point is that a distribution of dividends is a transfer of shareholder value from the company to the equity holder. So, we need to identify the maximum amount that a company could pay out in a given period leaving the operating capacity unimpaired. That must be the operating cash surplus of the business less any net reinvestment required to maintain capacity. What goes on in the income statement is really irrelevant because when it comes to a toss up as to which is likely to be the most faithful reflection of the underlying economic reality of a business the cash flow statement has it. Everytime.