EMPIRICAL ANALYSIS OF DETERMINANTS OF DIVIDEND PAYMENT:

PROFITABILITY AND LIQUIDITY

Norhayati Mohamed, Wee Shu Hui, Normah Hj. Omar, Rashidah Abdul Rahman,

Nor’azam Mastuki, Maz Ainy Abdul Azis, Shazelina Zakaria

Accounting Research Institute &Faculty of Accountancy,

Universiti Teknologi MARA, 40450 Shah Alam, Selangor, Malaysia.

Phone: +603-5544-4975

e-mail: weesh411@salam.uitm.edu.my; wee.shu.hui@gmail.com

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Abstract: This paper empirically analyzed the determinants of dividend payment for the

top 200 companies in terms of market capitalization, listed on the Malaysian share

market. Large firms were chosen to increase the likelihood of capturing dividend payers.

The findings showed that firms paid out on average, about 40 percent of their earnings

as dividends. Furthermore, a quarter of their operating cash flow was used to pay

dividend. Lastly, the study confirms the fact that profitability and liquidity were important

determinants of dividend payment.

Note: We would like to thank the Minority Shareholder Watchdog Group (MSWG) of Malaysia for
their collaboration. The data collected for this study was part of a collaborative work between
MSWG and UiTM.

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 INTRODUCTION

The topic of dividend has been extensively studied. Yet it remained as one of the most

controversial subjects in Finance. Studies in the past have covered many facets of

dividends; among them are effects of dividend payment on firm value, reasons for

paying dividends, determinants of dividend policy, and dividend trends, among others.

Despite the many theories and models put forth to explain the dividend phenomena,

empirical evidence is necessary to establish the practice of theoretical concepts. Such

evidence as documented through statistical tests would confirm the relevance of theories

or dispel them as myths.

Problem Statement

In Malaysia, dividend payment matters. Several studies have shown that an

announcement of dividend increase (decrease) was followed by an increase (decrease)

in share prices (Norhayati, 2005, and Nur-Adriana et al., 2002). With the proliferation of

unit trusts in Malaysia, investors were made more aware of returns in the form of

dividends. Furthermore these funds represent an important investing arm that invests in

shares that give good returns in the form of capital gains and dividend payments.

Therefore, a study on determinants of dividend policy will be a relevant decision in view

of this phenomenon.

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There are many company characteristics that have been found to be related to dividend

policy such as the firm’s profitability, liquidity, size, ownership structure and capital

structure, among others. Among these characteristics, profitability and liquidity are the

two main variables that affect a manager’s decision to pay dividend for that financial

period.

Usually only firms that are profitable will pay dividends. Some firms in Malaysia have

very high dividend payout ratio (DPR). According to a survey performed by Normah et

al. (2006), the highest dividend payout average for years 2003 – 2005 of 212 companies

surveyed was about 83 percent. This showed the heavy emphasis that some firms

placed on dividend payment. On the other hand, it is not surprising if some firms also

paid out dividends even though they reported a loss for that year. This is due to the

reluctance of firms to cut or omit dividends due to research findings which have shown

that investors, in both developed and emerging markets, react negatively to a dividend

decrease (Aharony and Swary, 1980; Dielman and Oppenheimer, 1984; Bajaj and Vijh

(1990, Denis, Denis and Sarin, 1994; NurAdiana et al., 2002 and Norhayati, 2005;

among others).

Liquidity is usually measured by the firm’s cash flow. It is very important to compare a

firm’s liquidity position in relation to its dividend payment. Logically, a firm will only pay

dividend if it has a strong cash position. However, many empirical researches have

concentrated only on profit flow and ignored the effect on cash flow. Cash dividend

distribution not only depends on the profitability of firms but also depends on the free

cash flow, which is the amount of operating cash flow left over after payment for capital

expenditures. According to Liu and Hu (2005), if the cash dividend is less than the free

cash flow, it means the firm has residual cash, if cash dividend is more than the free

cash flow then it means the firm needs financing to meet the requirement of cash

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dividend. The agency cost explanation has been popularly used to evaluate this

phenomenon and it will be further elaborated in the next section.

The study therefore addresses the question whether profitability and cash flow are

important determinants in dividend payment in Malaysia. In other words, do the

companies that pay dividend also have strong profitability and liquidity positions? It also

attempts to see whether two different measurements of profitability, namely earnings per

share and return on equity, can be used interchangeably as a proxy for profitability in

measuring the determinants of dividend payment.

LITERATURE REVIEW

In this section, the paper will present a few basic areas of dividend research. First, it will

briefly discuss a few findings concerning dividend trends. Second, it will discuss the

determinants of dividend policy, specifically the study by Lintner (1956), and company

characteristics such as profitability, liquidity and size.

Dividend Trends

In the study of dividend trends, Fama and French (2001) found that the percentage of

dividend paying firms in the United States (US) fell from 67 percent of listed firms in

1978 to 21 percent in 1999. Ferris, Sen and Yui (2006) documented similar findings in

the United Kingdom (UK) market, a market that is similar to that of the US in terms of

breadth and maturity. Their findings showed that the number of dividend paying firms in

the UK declines over the sample period and is most pronounced for the last five years of

their analysis. At the beginning of the sample period, nearly 76 percent of UK firms paid

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dividends, but by 2002, only 54.5 percent of the sample firms pay dividends. They also

found a similar decline from 60.2 percent to 28.6 percent for newly listed firms in the UK.

For the emerging market, Norhayati (2005) documented a similar pattern in her study of

companies listed on the Kuala Lumpur Stock Exchange (now known as Bursa Malaysia);

however, the pattern seemed to relate very much to the economic cycle. Her sample

excluded companies in the Finance and Unit Trusts sectors and was limited only to final

dividend announcements. Her findings showed from years 1981 to 1991, the

percentage of firms that paid dividends went down from 75 percent to 63 percent,

however, the percentage of payers increased to 83 percent in 1992 and continued to

increase up until 1997, and went on a downward trend from that year where there were

only 55 percent final dividend payers in year 2000. Please be noted that Malaysia

experienced two economic downturns in the sample years, one in 1987 and the other in

1997. And the downward trend in dividends coincides with the years before the

economic downturn and later picked up after the economy recovered.

Determinants of Dividend Policy

Many theories and models have been put forth to examine the numerous facets of

dividend study. The seminal article by Miller and Modigliani (1961) is probably the

watershed in the theoretical modeling of dividends, which first proposed dividend

irrelevance. On the other hand, theories which support dividend relevance include tax

preference, signaling, and agency explanations. Other researchers have developed and

empirically tested various models to explain dividend behavior. Some conducted

surveys of corporate managers to learn the most important determinants of corporate

dividend activity.

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The first empirical study of dividend policy was performed by Lintner (1956). Through

his interview with managers of 28 selected companies, he discovered that managers

tend to value stable dividend policies, dividends are increased gradually and rarely cut

and that most companies have reasonably definitive target payout ratios. Over the

years, the company will adjust the dividends at a particularly speed of adjustment, so

that the actual payout ratio moves closer to the target payout ratio.

Profitability

Company characteristics that affect firms’ dividends policy include the firm’s profitability,

liquidity, size, ownership structure and capital structure, among others. The discussion

here will concentrate on profitability, liquidity and size.

Several surveys provide useful insights into what factors financial managers considered

most important in determining their firm’s dividend policy. Baker, Farrelly, and Edelman

(1985) and Farrelly, Baker, and Edelman (1986), surveyed 562 New York Stock

Exchange (NYSE) firms with “normal” kinds of dividend polices in 1983. Based on their

analysis of 318 responses from utility, manufacturing, and wholesale/retail firms, they

found that the major determinants of dividend payments were the anticipated level of

future earnings and the pattern of past dividends.

Pruitt and Gitman (1991) surveyed financial managers of the 1,000 largest US firms

about the interplay among the investment, financing, and dividend decisions in their

firms. Their evidence suggested that important influences on the amount of dividends

paid were current and past years’ profits, the year-to-year variability of earnings, and the

growth in earnings. Baker and Powell (2000) found support for their hypothesis that the

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most important factors influencing a firm’s dividend policy are the level of current and

expected future earnings and the pattern or continuity of past dividends.

Aivazian, Booth and Cleary (2003) found that emerging market firms exhibit dividend

behavior similar to US firms, in the sense that dividends are explained by profitability,

debt, and the market-to-book ratio; however, their sensitivity to these variables varies

across countries.

DeAngelo et al. (2004) posited that the high/increasing dividend concentration may be

the result of high/increasing earnings concentration. Their findings supported this

contention and they found that just as dividend concentration had increased; so did the

concentration of earnings. Earnings in both 1978 and 2000 of the sample firms are

concentrated among a relatively few firms at the top end of the distribution, and that

such concentration is notably greater in 2000 than it was in 1978. There was also strong

link between losses and the failure to pay dividends. Their findings suggest that

earnings do have some impact on dividend payment.

Goergen et al. (2005) analysed the decision to change the dividend for 221 German

firms over 1984–1993. Their results showed that net earnings were the key

determinants of dividend changes. In addition, their findings showed that the occurrence

of a loss is a key determinant in addition to the net earnings level. They observed that

80 percent of the loss-incurring German firms, with at least five years of positive

earnings and dividends preceding the loss, omit the dividend in the year of the loss.

Baker and Smith (2006) surveyed 309 sample firms exhibiting behavior consistent with a

residual dividend policy and their matched counterparts to learn how they set their

dividend policies. Their results showed that for the sample and matched firms, the

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pattern of past dividends, the level and stability of earnings, and desire to maintain a

long-term dividend payout ratio elicit the highest level of agreement from respondents.

Ferris et al. (2006) found mixed results for the relation between a firm's earnings and its

ability to pay dividends. Few U.K. firms with negative earnings pay dividends while 73%

of comparable Japanese firms do. The UK economy increasingly resembles a two-tier

system with a small set of very high earners providing a disproportionate percentage of

aggregate dividends.

In Malaysia, Annuar and Shamsher (1993) investigated the dividends and earnings

behavior of firms listed on the Kuala Lumpur Stock Exchange (KLSE). The data used

consist of annual earnings and dividends for the period 1975 to 1989. Their findings

were that the dividend decisions of the firms partially depended on their current earnings

and past dividends, and firms have long-term target dividend which is conditioned upon

their earnings ability.

In conclusion, profitability is an important determinant of a firm’s dividend policy.

Size

Fama and French (2001) found that payers and non-payers differ in terms of profitability,

investment opportunities, and size. Their evidence suggests that three fundamentals –

profitability, investment opportunities, and size – are factors in the decision to pay

dividends. Dividend payers tend to be large, profitable firms with earnings on the order

of investment outlays. Firms that have never paid are smaller and they seem to be less

profitable than dividend payers, but they have more investment opportunities, and their

investment outlays are much larger than their earnings. The salient characteristics of

former dividend payers are low earnings and few investments. Mitton (2004) wrote that

size and growth, in addition to profitability has been proven to be positively correlated

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with dividend payouts. Li and Lie (2006) reported that firms are more likely to raise their

dividends if they are large and profitable and the past dividend yield, debt ratio, cash

ratio, and market-to-book ratio are low. Firms are more likely to cut their dividends if

they have poor operating income, low cash balances, and a low market-to-book ratio.

Cash Flow

Liu and Hu (2005) in his study of Chinese listed firms found that cash dividend payout

ratio of most firms were between 20 to 50 percent, meaning that cash dividend payment

was higher than the accounting profit. However, he found that 50 percent of the sample

firms had dividend cash payment higher than the free cash flow. He attributed this

finding to the ruling made by the security commission of China in 2000 which stated that

listed companies must have cash dividend payment in the past three years. This

shortage of cash was usually financed through selling shares or right issue.

One theory that can be used to explain why firms borrow money to pay for dividends is

the agency theory. Agency theory has also been a popular view in the discussion of

dividends relevancy, as been advanced by Jensen and Meckling (1976), and later

extended by Rozeff (1982) and Easterbrook (1984). Agency theory posits that there is

a conflict of interests between the managers (agents) and the outside shareholders

(principals). Managers may consume excessive perquisites out of undistributed

earnings or they may invest the earnings in less than optimal investments. This conflict

of interests is referred to as agency costs. Dividend has been identified as a mechanism

that can reduced agency costs. By paying out a large dividend, it reduces the amount of

funds available for managers to spend excessively on perquisites. Furthermore, the

larger dividend payment forces the firm to seek external financing, which will subject it to

the scrutiny of the capital market for new funds and reduces the possibility for

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suboptimal investments. Therefore, according to the agency theory this will reduce the

monitoring costs to the firm. In short, if the costs involved in paying dividends are less

than the benefit gained from the additional monitoring, then it makes sense for

companies to have large dividend payouts. Rozeff (1982) postulates and finds evidence

that firms establish higher dividend payouts when insiders hold a lower fraction of the

equity and/or a greater number of stockholders own the outside equity. This evidence

supports the view that dividend payments are part of the firm’s optimum monitoring and

bonding package and serve to reduce agency costs.

DATA DESCRIPTION AND SAMPLE CONSTRUCTION

This study was conducted on Malaysian companies over a 3-year period from 2003 –

2005. The sample was taken from the top 200 companies listed on the main board of

Bursa Malaysia based on market capitalization as at 31 December 2005. For the years

2003 and 2004, ten companies were excluded from the sample due to the unavailability

of information. Therefore, the total number of companies for the three years was 580.

According to several studies, bigger firms tend to be payers of dividends and they also

tend to pay higher dividend (Fama and French, 2001; Mitton, 2004; and Li and Lie, 2006,

to name a few). For this study, we chose to include the bigger firms, which are the top

200 firms based on market capitalization, in order to capture the dividend payers.

For each company, the information on dividend per share (DPS), earnings per share

(EPS), return on equity (ROE) and cash flow per share (CFPS) for the three years were

collected. They were collected from Data Stream and were verified by checking through

each company’s annual report. DPS is the total cash dividend (interim and final) paid by

the firm for each number of share outstanding. EPS is net income per share, ROE is net

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income per each ringgit invested by the shareholders, and CFPS measures the

operating cash earnings per share of the company. EPS and ROE are proxies for

profitability while CFPS is the proxy for liquidity.

Statistical tests in the form of correlation and regression tests were undertaken to

examine whether liquidity and profitability affect the distribution of dividends.

Theoretically, as discussed earlier, liquidity and profitability determine the ability of

companies in distributing dividends.

FINDINGS

This section presents the findings of the study. First, it describes the percentage of

payers versus non-payers in the sample over the three years. Second, it gives the

dividend distributional characteristics of the sample firms. Third, it discusses the

dividend payout characteristics. Fourth, it discusses the statistical analysis in terms of

the correlation and regression results.

Percentage of Payers and Non-Payers

This section describes the findings in terms of whether or not the companies are payers

of dividends. A comparison of percentage of payers to non-payers was analyzed on a

yearly basis from available data. The majority of companies paid dividends.

The study found that 87 percent paid dividends, whether interim or final, in the year

2003. The percentage of dividend payers was maintained at 87 percent in 2004 but in

2005, there was an increase to 91 percent. The majority of companies paid dividends in

the three-year period as shown in Table 1. While the trend of companies paying

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dividends is rising, some companies have yet to consider paying dividend and to state

their dividend policy for the three years.

Table 1: Percentage of Dividend Payers versus Non Payers, 2003 – 2005

2003 2004 2005

Payers 87% 87% 91%

Non-Payers 13% 13% 9%
Total 100% 100% 100%

Dividend Distributional Characteristics

In Table 2, the sample was divided into payers and non-payers category. The payers

category was further divided into quartiles where the first (1st) quartile consists of the

bottom most 25 percent of dividend payers, the second (2nd) quartile consists of the

second 25 percent of the lowest dividend payers, and so on and so forth. As can be

seen from the table, those companies not paying dividends are those with the lowest

profitability as indicated by EPS and ROE, and also the lowest liquidity as indicated by

the lowest cash flow. On the other end are those which paid the highest dividends and

their profitability and liquidity were also the highest.

Table 2: Distributional Statistic of Dividend per Share

Quartile No of DPS EPS ROE CFPS

Observation (RM) (RM) (%) (RM)
Non payers 67 0.000 0.027 25.7 2.163

1st 128 0.021 0.113 25.0 8.280

2nd 128 0.059 0.200 34.0 10.830

3rd 128 0.114 0.297 44.3 12.627

4th 129 0.315 0.544 81.5 17.388

Whole sample 580 0.113 0.259 43.9 11.121

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Dividend Payout Characteristics

This section presents a yearly analysis among payers, on the relationship between each

of the characteristic, namely, profitability and liquidity, with DPS. Profitability is measured

by EPS and ROE while liquidity is measured by CFPS. Referring to Table 3 one can

calculate the dividend payout ratio (DPR) by taking EPS divided by EPS. The yearly

average DPR ranges from 38.7 percent to 44.8 percent. This means that on average,

the firms in the sample paid out about 40 percent of their earnings in the form of

dividends. The results also show that on average, the dividends consume about one

quarter of the firms’ cash flow.

Table 3: Yearly Analysis on the Association between average DPS and EPS, and
DPS and CFPS, 2003 – 2005

2003 2004 2005

DPS (RM) 0.10 0.12 0.13
EPS (RM) 0.25 0.31 0.29
CFPS (RM) 0.41 0.48 0.43
DPR (%) 40.0 38.7 44.8
DPS/CFPS (%) 24.4 25.0 30.0

Statistical Tests

A correlation test of the four indicators, DPS, EPS, ROE and CFPS was run to examine

whether the above-mentioned associations of relationships could be established. The

correlation results as shown in Table 4 indicate significant positive relationships between

DPS and EPS, CFPS and ROE. This confirms that profitability and liquidity are strongly

related to dividend distribution policy.

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 Table 4: Correlation Matrix of Regressors

DPS EPS CF ROE

DPS 1.00
EPS .526** 1.00
CF .462** .676** 1.00
ROE .369** .668** .266** 1.00
Notes: The correlation coefficients are based on the final sample of 580 firm-year observations.**0.05 level
of significance

Regression Results

However, further test is needed to positively identify that liquidity and profitability are

determinants of dividend distribution policy. Pooled regression analysis was done to

examine whether such a relationship existed. Three regressions were run, the results of

which are shown in Tables 5, 6 and 7.

The first regression was done to examine whether EPS, CFPS and ROE are significant

determinants of dividend payments. It can be seen in Table 5 that in each of the three

years and in total, the three indicators are significant determinants of dividend payments.

The strength of the relationship is indicated by the adjusted R2. In 2003, the three

indicators explain for 63 percent of the dividend payments but this falls to 43 percent in

2004 and decreases to 35 percent in 2005 but they are all significant. When the three

years are pooled together, the result confirms that the three indicators are significant

determinants of dividend payments.

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 Table 5: Determinants of Dividend per Share; EPS, CFPS and ROE

Pooled 2003 2004 2005

EPS .295** .260** .362** .231**
CFPS .233** .214** .204** .294**
ROE .110** .457** .174** .168**
Adjusted R2 .300 .633 .431 .336
F-value 83.78** 109.55** 48.99** 34.71**
Firm-year 580 190 190 200
Notes: ** 0.05 level of significance

One may argue that there are two indicators of profitability, EPS and ROE and this may

skew the results. So, a second regression was run without ROE. The result in Table 6

indicates similar results. The pooled data shows that EPS and CFPS are significant

determinants of dividend payment policies. The strength of the relationship as

determined by adjusted R2 remains similarly strong.

Table 6: Determinants of Dividend per Share, EPS and CFPS

Pooled 2003 2004 2005

EPS .394** .727** .543** .372**
CF .196** .016 .146 .256**
Adjusted R2 .295 .542 .425 .325
F-value 122.40** 112.70** 71.10** 49.14**
Firm-year 580 190 190 200
Notes: ** 0.05 level of significance

Is ROE a better indicator of profitability than EPS? The regression result in Table 7 does

not indicate any difference in the strength of the relationship although the result confirms

that CFPS and ROE are significant determinants of dividend payments. The pooled

16
adjusted R2 remains at 0.3. There is no indication to suggest that ROE is a better

determinant than EPS.

Table 7: Determinants of Dividend Per Share CFPS and ROE

Pooled 2003 2004 2005

CFPS .265** .368** .374** .409**
ROE .392** .584** .393** .288**
Adjusted R2 .279 .620 .410 .322
F-value 111.59** 155.39** 67.09** 48.60**
Firm-year 580 190 190 200
Notes: ** 0.05 level of significance

CONCLUSION

First, the results from the descriptive and statistical tests reveal that dividend is indeed

an important variable for firms. In this study, 200 companies with the highest market

capitalization were chosen as a sample. With large size companies it is hoped that this

study would be able to capture more dividend payers. From the descriptive analysis it

was found that firms paid out about 40 percent of their earnings in dividend. And on

average, about a quarter of their operating cash flow was used to pay out dividends.

Second, EPS, ROE and CFPS are significant determinants of dividend payments. This

study actually separates the effect of earnings and cash flow on dividend payment.

Third, EPS and ROE, whether used together or separately are useful indicators of

profitability. This supports the fact that companies which are profitable and liquid will be

more likely to declare dividends.

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In conclusion, through a simple descriptive and statistical analysis, this study confirms

the fact that profitability and liquidity are two important determinants of dividend. The

analysis can be considered as exploratory and in the future, the scope should be wider

and more variables should be included. The analysis should include analysis across

industries, and should also include more variables such as corporate governance and

other company characteristics. The sample size should also be increased and could

include all companies listed on the main board of Bursa Malaysia. With those additions,

the results and analysis will be richer and hopefully will help unravel the mystery of the

dividend puzzle.

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