Permission and Ability: The Dividend Decision
Decide whether the company may pay the dividend it is proposing. It has to pass two tests, not one. Net Income is not one of them.
A dividend is a share of profit handed to the owners of a corporation. Before the directors can pay one, the company must pass two gates — and it must pass both.
| Gate 1 — Permission | Gate 2 — Ability |
|---|---|
| Look at Retained Earnings | Look at the Cash Balance |
| Profit the company earned and kept | Real money in the bank |
| Only profit you have made can be given away | A dividend is paid in cash |
Key Concept: Retained Earnings are a record of profit kept in the business, not money in the bank — it may already have been spent. A big Net Income answers neither gate.
Net Income: $8,000
Retained Earnings: $5,000 (Gate 1 — low!)
Cash Balance: $26,000 (Gate 2 — plenty)
Proposed Dividend: $7,000
Answer: NO! Gate 2 is passed — the bank has plenty. But the company kept only $5,000 of profit, so Gate 1 stops it. The most it could pay is $5,000.