Alternatively, a firm cannot pay cash dividends greater than the amount of current profits plus the accumulated balance of retained earnings. For instance, section 205 of the Indian Companies Act provides that dividends shall be paid only out of the current profits or past profits after providing for depreciation. The point to be recognized is that the company can count on the profits of previous years, if the current year’s profits fall short of the required funds for maintaining a desired stable dividend policy. Likewise, if there are past accumulated losses, they should be first set off against current earnings before the payment of dividend.
A firm is said to be insolvent in two situations: first, when its liabilities exceed the assets; and second, when it is unable to pay its hills if the firm is currently insolvent in either sense, it is prohibited from paying dividends. Similarly, a firm would not pay dividends if such a payment leads to insolvency of either type. The rationale of the rule is to protect the creditors by prohibiting the liquidation of near bankrupt firms through cash dividend payments to the equity owners.