Distributing profits to shareholders is a significant milestone for any close-held business, but doing so without examining key financial metrics can drain an enterprise of necessary working capital.
In jurisdictions like Nigeria, paying dividends from the wrong pool of funds also carries severe legal consequences. Under the Companies and Allied Matters Act (CAMA) 2020, directors who recommend or pay dividends when the company is insolvent can be held personally liable for the debts of the firm.
Distributable profits versus revaluation gains
Accounting profit on the income statement does not automatically translate to legally distributable profit. Under Section 427 of CAMA 2020, dividends can only be paid out of accumulated, realised profits less accumulated, realised losses.
SME owners must look closely at the composition of their retained earnings. Paper profits, such as unrealised foreign exchange gains or asset revaluation surpluses, must be stripped out before calculating what is available for distribution.
For example, if a Lagos-based logistics firm revalues its warehouse properties upward by 50 million Naira, its balance sheet will reflect an increase in equity. However, this revaluation surplus is not a realised profit and cannot be used to pay dividends.
Free cash flow and working capital cushions
A business can show strong paper profitability while simultaneously facing a cash crunch. This mismatch often occurs when a company operates on an accrual accounting basis and has generous credit terms for customers.
Before declaring a dividend, management must calculate free cash flow, which is the cash generated from operations minus capital expenditures. If net income is high but accounts receivable are bloated, the cash required to pay shareholders simply does not exist in the bank account.
Consider an Abuja-based packaging distributor that records 120 million Naira in net profit, but has 90 million Naira locked in unpaid invoices from retail clients. Paying a dividend based on the net profit figure would force the firm to borrow at high commercial interest rates to cover daily operational costs.
Debt covenants and solvency ratios
SMEs with active bank loans or credit lines must review their loan agreements before making distributions to owners. Commercial lenders regularly include covenants that restrict or entirely prohibit dividend payments under specific conditions.
The key metric to review here is the debt service coverage ratio (DSCR), which measures the company’s ability to pay its current debt obligations with its operating income. If paying a dividend drops this ratio below the lender’s threshold, the business could face immediate loan recall.
Similarly, the current ratio, which compares current assets to current liabilities, must remain robust. If a dividend payment reduces cash assets so much that the current ratio falls below 1.5x, the SME may struggle to pay its trade creditors and staff on time.
Before the board of directors proposes a dividend, the finance team should prepare a formal twelve-month cash flow projection. This projection acts as a solvency test, proving that the company can comfortably meet its operational liabilities and debt obligations after the funds leave the business.
