A liquidating dividend is a type of dividend paid by a company to its shareholders when it goes through a full or a partial liquidation. Such dividends are mostly distributed by using the capital base of a company. This makes liquidating dividends different from regular dividends, as the latter are distributed out of a company's profits or retained earnings.
To put it simply, a company pays liquidating dividends when it is at the end of its existence and it wants to distribute the remaining value of its operations among its shareholders. Having discussed what liquidating dividend is, let us delve deeper into this topic.
Working of Liquidating Dividend
Many steps are involved in the process of liquidating dividends. The first step requires a company to examine its financial position to find out the right course of action to cease its day-to-day operations. Having decided that, a company starts to dispose of its assets, which typically include equipment, plant, machinery, real estate, etc.
Then, a company has to pay its outstanding debts using the proceeds from the sale of its assets. Whatever remains after paying the outstanding debts is distributed amongst its shareholders as a liquidating dividend.
Formula for Calculating Liquidating Dividends
You can calculate the liquidating dividend of a company using the following formula:
Liquidating Dividend = Total Assets Sold by a Company – Total Liabilities of a Company – Expenses involved in the Process of Liquidation
Example of a Liquidating Dividend Calculation
The concept of liquidating dividend will become clearer by taking an example. Let us say that a company decides to wind down its operations. It manages to sell all the assets for ₹ 10 crore, but it has to pay loans and obligations amounting to ₹ 5 crore. On top of it, liquidating expenses amount to ₹ 50 lakh. So, we can calculate liquidating dividend by using the formula explained above:
Liquidating Dividend = ₹ 10 crore – ₹ 5 crore – ₹ 50 lakh = ₹ 4.5 crore
Hence, the company will distribute liquidating dividends amounting to ₹ 4.5 crore amongst its shareholders.
Process of Issuing Liquidating Dividends by Companies
When it comes to issuing liquidating dividends, firms must comply with certain specific legal and regulatory processes, which ensure that the interests of all kinds of stakeholders, whether shareholders or creditors, are taken care of.
The decisions to liquidate assets, pay external obligations, and distribute liquidating dividends are taken by a company’s board of directors. After getting an approval from the board, a firm has to file the required documents with the authorities and announce its liquidation to its shareholders.
Liquidating Dividend vs. Regular Cash Dividend
While a liquidating dividend and a regular cash dividend are kinds of payments made by a firm to its shareholders, they are essentially different.
A firm pays a regular cash dividend from its profit. It is a way to reward its shareholders for showing faith in the firm’s potential. Hence, in most cases, a regular cash dividend shows that a firm is performing well.
However, a liquidating dividend is paid when a firm shuts down its operations partially or entirely. The funds for a liquidating dividend are sourced from the sale of a company’s assets and not from its profit.
Liquidating Dividend vs. Bonus Dividend
A liquidating dividend and a bonus dividend are meant for different objectives and serve different purposes. A company pays bonus dividends on the top of regular dividends from its surplus profits.
For example, a firm can decide to pay bonus dividends after performing superbly in a year. But, a bonus dividend is not a regular payment, as it is paid once in a while.
On the other hand, a company pays a liquidating dividend when it is shutting its operations or its existence is coming to an end. It is paid out of the sale proceeds of a firm’s assets. Hence, the circumstances in which a bonus dividend and a liquidating dividend is paid are altogether different.
Significance of Liquidating Dividends
Liquidating dividends are important for both firms and their shareholders, especially when a firm faces a challenging situation. Let us say that a company is facing bleak prospects for its products and it becomes extremely difficult for it to continue its operations. In such a situation, liquidating dividends can provide an exit strategy to the firm.
It can allow the firm to sell its assets, pay its obligations, and distribute the remaining amount as liquidating dividends to its shareholders. A company can decide to cease to exist for a variety of reasons, like high debt levels and changing market dynamics. In all such situations, liquidating dividends can provide a company with a strategy to gracefully shut down its operations by honouring all its obligations and commitments.
Advantages of Liquidating Dividends
Liquidating dividends have many benefits, which are explained below in great detail:
Exit strategy for companies: Liquidating dividends provide firms with exit strategy when they face challenges that can threaten their existence. Using a liquidating dividend, firms can meet all their obligations and distribute dividends to their shareholders.
Improves investors’ confidence: When a company distributes liquidating dividends to their shareholders even amidst challenging circumstances, it improves the confidence of investors in the company. If the management or key personnel of such a company raise finance later for another venture, investors may show interest in that.
Restructure investors’ portfolios: When a firm provides liquidating dividends to its shareholders, they can invest the funds thus received in other companies that align with their objectives, thereby restructuring their portfolios.
Drawbacks of Liquidating Dividends
While liquidating dividends have benefits, they have certain limitations as well, which are explained below:
Potential of a limited payoff to shareholders: Companies with huge debts or liabilities may find that a large part of their assets’ value is required to pay these obligations. Hence, after making these payments, they may be left with only a limited payoff for their shareholders.
Lack of clarity regarding timings: A firm may spend a lot of time in selling its assets and paying its debt. Worse still, it may not even know how much time it will spend in performing these actions. Hence, shareholders may not know when they will receive liquidating dividends.
Dependence on market conditions: A company’s ability to sell its assets depends upon market conditions to a great extent. If market conditions are not conducive, it may not be able to get the right value for its assets, which can badly affect the amount of liquidating dividends shareholders expect to receive.
Final Thoughts on Liquidating Dividends
If you are an investor, you ought to understand the concept of liquidating dividends well. Knowing this concept will help you manage your finances when the companies in which you are invested cease to exist. Apart from understanding what liquidating dividends are, you also should know where or in which companies to invest the amount you receive as such dividends to restructure your portfolio.