ASX dividend stocks are known for paying attractive passive income through dividends. But, dividends are not guaranteed payments. I'm going to outline why there are two huge reasons to be cautious about ASX dividend shares.
Companies are only able to pay a dividend if they make a profit. It can take some businesses some time to be large enough to make a profit. Zip Co Ltd (ASX: ZIP) is still striving to be profitable despite being listed for a number of years.
It's not easy to make a profit. Recessions can cause difficulties, while competition can harm margins and growth. ASX travel shares' profit was smashed over the last few years.
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Dividends can be cut
ASX dividend stocks may want to pay shareholders good passive income. But if profit falls then the board will have a tough decision to make.
If a business is committed to a particular dividend payout ratio, such as 50% or 75% of profit, then a fall in profit will certainly reduce the dividend payment.
We recently saw that in the BHP Group Ltd (ASX: BHP) half-year result, which showed a 32% fall in both attributable profit and earnings per share (EPS). This led to a 40% cut of the interim dividend per share of 90 cents per share. Some businesses have relatively consistent profits, while others (such as commodity businesses) can see significant changes.
A board of directors could also decide that the balance sheet isn't healthy enough to pay out a lot of cash. If there is a lot of debt, it may make more sense to repay that debt now that interest rates are much higher.
But, that's not the only reason investors may want to think twice about ASX dividend stocks.
Better to re-invest?
Some businesses like Commonwealth Bank of Australia (ASX: CBA) may have a particularly high dividend payout ratio because there's not that much that the business can invest in to grow its core business.
But, a business like Berkshire Hathaway has shown what can happen if a company continues to re-invest in its operations rather than paying out a dividend.
A dividend payment may only be worth a dividend yield of 2% or 3% in an investor's bank account from an ASX dividend stock. But, if a company retains the cash then it may be able to earn a 10% return or more on that cash. The stronger the company's return on equity (ROE), the more sense it typically makes for a business to re-invest.
So, investors may do better overall by choosing businesses that are re-investing more of their profit.
Foolish takeaway
Of course, I'm not trying to say that all companies shouldn't pay dividends.
We should expect cyclical businesses to pay cyclical dividends.
On the re-investment side of things, there won't always be opportunities to invest in, and acquisitions can go wrong. Plus, for Aussies, it can be beneficial to unlock some of the franking credits. Dividends do make sense sometimes.
