If dividends per share are in surplus of earnings per share then a company must be making the dividend payment out of reserves. In other sense the net asset value of the business will be reduced by the extent of the difference in value between the dividend payout and the earnings.

Erosion of the net asset value will be a matter of distress to the investor if either:

- The fall in value is substantive or

- The Company accept this strategy over a number of successive years.

One cause why a company may adopt such a policy can be explained by the common perception that the share price will fall if dividends are reduced. Therefore market forces encourage company directors to feel that it is preferable to pay the necessary dividend out of reserves if such a strategy will help to maintain the share price. An option reason is that if a company has a very high level of reserves, and is unable to find suitable uses for the funds, then it may feel that paying those funds back to investors is a sensible and more appropriate policy. In this case the dividend which is elevated than an earnings is merely a repayment of earnings from earlier years back into the hands of the equity investors. In such instance directors are often criticised for their inability to identify suitable investment opportunities, and the strategy may well only be adopted as a last resort measure.

The hazards of making payments out of reserves are two-fold. Firstly the action might trigger a stock market reaction which sends the share price on a downward spiral and this denotes that in the medium to longer term the shareholders are worse off. In the short term they have been salaried by the high dividend but in the longer term this may be inadequate to cover the fall in the value of the shares.

Secondly the drop in the net asset value of the business may make it more vulnerable to a takeover. The market is as well likely to react to the implementation of such a policy and this may mean a downward adjustment in the share price. Finally if a company make payments out of reserves over an extended period of time this may bring into question its future trading viability. In practice but it is unlikely that such a situation would arise.