Decoding Dividend: Why Profits Matter More Than Cash

Dividend is the most transparent return for the shareholders, but the law sets stringent limits on when and how it can be issued. At the center of these constraints is the concept of capital maintenance, which safeguards creditors and maintains fairness in corporate management.

Why Capital Profits Cannot Be Distributed as Dividend

Capital profits are those arising from transactions of a capital nature – such as share premium, revaluation of assets, amalgamation reserves, or gains on the sale of fixed assets. These are classified as capital reserves, not “free reserves.”

The Companies Act, 2013 prohibits the use of capital reserves for dividend, except in very limited circumstances like issuing bonus shares, writing off capital losses, or reducing capital with Tribunal approval.

The reasoning is simple:

• Capital = Creditors’ cushion. Creditors lend to the company with the hope of its share capital and surplus profits acting as a safety net playing with this would result in lack of trustability in company constitution.
• Dividend must be from profits, not capital. Permitting dividend from capital reserves would allow the promoters to divert money out, leaving the creditors in the lurch Raise funding declare dividend simple scheme.
• Nature of capital profits. Many capital profits are unrealized (like revaluation surplus), or represent adjustments to maintain financial stability, not distributable surplus.

So, although shareholders might consider that “capital profits are also gains,” law specifically disallows them from dividend distribution.

Then Why Do Shareholders Get Capital Back on Liquidation?

This is where the timing and priority matter.

• The business is no longer a going concern in liquidation. All assets are cashed in and the creditors paid first in order of priority.
• Only after every creditor is settled do shareholders receive what remains – including capital reserves.
• This ensures that creditors’ interests are not compromised while the company is in operation.

If capital reserves were allowed to be distributed during normal business:

• Creditors would lose the very cushion they depend on.
• Promoters could raise capital, immediately declare it out as dividend, and walk away – a direct fraud on lenders.

Hence, law distinguishes between:

• Going concern stage → shareholders get dividends only from profits.
• Liquidation stage → shareholders get back capital, but only after creditors are safe.

 Illustration: Profit vs Cash in Dividend Declaration

To see this in numbers, consider a company that reports:

Here, although most of the ₹1 crore sales sit in debtors, the company still shows ₹49 lakh profit in books. Dividend of ₹25 lakh can be legally declared, and even if the company pays it from cash received through an asset sale, it remains valid because the basis was profit, not cash source.

Had there been no profits or free reserves, dividend would have been prohibited, regardless of how much cash was in the bank.

The Governance Rationale

Some companies have tried to exploit the system – inflating sales, declaring dividends out of fictitious profits, and later writing off receivables as bad debts. Famous examples include Satyam Computers in India and Enron in the US. In such cases, . In these instances, dividends essentially flowed out of capital, prejudicing creditors.

To prevent this, the Companies Act not only prohibits dividends from capital profits but also punishes fraudulent declarations severely (Section 447 on fraud, and directors’ personal liability under Section 123(7)).

 Conclusion

Dividends are not just about distributing cash. They are about distributing genuine profits while preserving capital for the protection of creditors.

• Capital reserves are not distributable because they represent the strength of the company’s financial base.
• Shareholders can eventually receive capital reserves in liquidation only after their creditors are secure.
• During normal business, dividends should go only from profits or free reserves, maintaining balance between reward to shareholders and protection of creditors.

In short, dividend law embodies the principle of capital maintenance – a safeguard that keeps the corporate ecosystem trustworthy and sustainable.