A Sudden Cut in Dividend

 (Extract From My Book "Psychology And Investment")

In case of any negative indications about the prospects of the company, the first possible action of management is to save all cash outflows of the company. Therefore, a sudden cut in dividends is a clear indication that the company may face a cash crunch or other challenges soon. A company may skip paying dividends if it plans to reinvest or cover costs.

Hence, an investor should keep a close watch on all developments and it is good to avoid such stocks for the time being. This type of action indicates that an investor needs to examine the financial position of the company further and they cannot take such type of information lightly.

When an established company that is paying dividends at regular intervals suddenly increases it, decreases it, or defaults in paying dividends, an investor should examine all the scenarios.

For example, suppose a company is declaring dividends every year and this trend is increasing. The financial health of the company is good and the stock is also performing well. Let us assume that the dividend trend of this company for the last few years is 40%, 60%, 75%, 90%, 100%, 120%, 140%; But the next year suddenly the company takes a deep cut and it declared a dividend of 40%. This indicates that the company is trying to save existing funds for any uncertainties that may arise shortly.

It's also not a very healthy sign if a company suddenly increases its dividend. Because then it will be difficult for them to maintain the same performance. In the example above, let's say that instead of a deep cut next year, the company announced a huge jump in a dividend payment of 1000%. Such kind of hefty payment cannot continue in the years to come. In such cases, the situation of dividend payment is not smooth and declaration of dividend is not normal. This unusual action demands further scrutiny of such kind of announcement. 

Because dividends provide a signal of a company's financial health, most companies are hesitant to reduce the amount already declared in the previous year. Even after facing problems from many fronts, the company does not want to give any negative signals in the market, hence, they continue with their stable dividend policy.

However, every reduction in dividend does not give a negative signal about the company, neither increase provides a positive signal. There are times when a company continues to pay a stable dividend and is not able to increase even for years.