Corporations possessing adequate capital can have but one genuine and proper use for surplus, and that is to stabilize dividends. The surplus is available for paying dividends to stockholders. Any other legiti mate expenditure can be made from current earn ings, or from the paid-in capital. Surplus, there fore, over and above dividend requirements, might as well be capitalized by a stock dividend. This brings to light an interesting fact. The piling up of un necessary surplus is often used to hide a shortage of capital. Surplus is usually supposed to have been created out of earnings, and the principal reason for not capitalizing any large surplus is to obtain the psychological effect of appearing to have earned large profits. As already stated, if the capital stock is worth less than par, this impression of accumulated profits is fictitious. But the surplus, nevertheless, tho it may be nothing more than a book entry, gives an atmosphere of stability which improves the bor rowing power of the corporation and perhaps has an effect upon the price of its stock in the market.
It is better for a corporation to pay a regular rate of dividend each year, gradually increasing the rate as profits increase, than to pay a highly fluctuating rate depending directly upon earnings from year to year. Investors in corporate securities desire steady income, and stability of market values. Regularity of dividends tends to accomplish both, tho market prices will always fluctuate with earnings, since earn ings must ultimately go to stockholders in some form unless consumed by losses.
The credit of a corporation is improved by steady dividends, since they lend an air of permanency and certainty to the business. By the accumulation of a reasonable surplus, profits may be actively retained in the business, yet legally available for dividends in unprofitable years, when dividends could not other wise be paid without impairing capital.
11. Fixing the dividend rate.—Granting that sur plus is not accumulated for the purpose of meeting a shortage in capital, but solely for the purpose of stabilizing dividends, the rate of dividend may be determined by adding the actual earnings of the cor poration over a period of years and dividing the total by the number of years covered. The result is the average annual, earnings during the period, and when divided by the par value of the capital stock, gives the rate of dividend which could have been paid with out impairing capital. The rate actually paid, how ever, should be somewhat less than the rate thus de termined, in order that a run of exceptionally bad luck, or unforeseen difficulties, may not entirely wipe out the surplus. All profits above this dividend rate
should go into surplus, and, when the earnings are less than the dividend, surplus may be drawn upon to pay the regular rate. In the case of new com panies without established earning power, the most conservative practice is to retain all earnings as sur plus until the surplus equals from five to ten per cent of the capital stock and then to begin paying small annual dividends of, say three or four per cent, which may be gradually increased every few years as ex perience indicates.
Dividends upon cumulative preferred stock should usually be paid annually if earned, without regard to surplus, but with care not to impair capital. Indeed, surplus has no true function except to average divi dend payments against earnings. The financial dif ficulties of our large industrial trusts during the first ten years of their existence arose mainly from the unsound policy of paying out liberal dividends, fre quently more than had been actually earned. These dividends were often for the purpose of sustaining the market for the stocks, so that the underwriters and promoters might unload their holdings at profit able prices. It is interesting to note that the best of these companies, as soon as the insiders had un loaded their promotion securities, changed their divi dend policy and began to accumulate a surplus for stabilizing future dividends.
The change of a dividend policy in order to strengthen surplus and the general position is illus trated by the experience of a Canadian bank, whose paid-in capital stock was $2,860,000. Its dividend record was as follows: At the end of 1915, the bank president frankly con fessed that it would have been a better policy to have retained a portion of the money paid in dividends for the establishing of a reserve to increase the earn ing power of the bank and as a protection against losses. In providing for losses and paying dividends the bank had not been able to build up such a reserve. This, the president said, would have to be done before profits could be distributed.
In order to adjust affairs the directors proposed a reduction in the capital of 50 per cent or $1,430,000. From this amount it was proposed to set aside one half, namely $715,000, in a reserve account—the bal ance to be used to write down bank premises, de preciation in assets, and to place a sufficient sum in a contingent account to provide for possible losses on unsecured loans.