Income investors should be aware that a company's dividend policy and its overall liquidity are intimately correlated. That notion is highlighted by knowing that a liquidity dividend is a company's available funds to cover dividends in the short term, say for the next several quarters. A company struggling to fund its dividend, or one with a poor liquidity dividend, could be a candidate to cut or suspend its dividend down the road.
A company's liquidity position is one of the easier corporate concepts for investors to understand. Put simply, liquidity is a company's ability to use current cash holdings or liquidate assets to service its debt and other corporate obligations, such as the dividend. Liquidity underscores why many investors prefer cash-rich companies. For example, assume a company has $1 billion in cash, an annual dividend obligation of $50 million and just $10 million in debt. The cash on hand is more than enough to pay its dividend for a long time and eliminate its debt. This is a company with a strong liquidity position.
When companies face the need to conserve cash because their liquidity positions have become crimped, a frequently employed tactic is to cut jobs. In some cases, investors approve of this action because it represents long-term costs savings and can mean a short-term pop for the stock. Another frequently used method of corporate cash conservation is cutting or eliminating the dividend. Many companies that do this frame the dividend cut as a liquidity-enhancing move, but dividend reductions are rarely greeted positively by investors.
Impact On Market Liquidity
One might assume that because a particular company pays a dividend that its stock might be more popular than those of a comparable firm that does not pay a dividend. A paper by researchers at Tulane University indicates there is actually a negative relationship between dividend payers and market liquidity over time. The research shows there is "evidence that market liquidity and firm likelihood to pay dividends are negatively related over time."
It can be argued that companies that pay dividends are empowering their shareholders. Those investors become accustomed to the dividend and do not want to see it threatened by misuse of profits for other corporate endeavors such as a botched acquisition. And that empowerment can boost liquidity, as highlighted by a University of Munich study. "When shareholders have more power, liquidity would be more strongly linked with dividends as managers would be more likely to pay dividends to meet shareholders' preference for liquidity," the study said.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.