When investors invest in a company, they consider how much returns they can get. Usually, these returns include two components. The first is any capital gain on the investment’s value over time. This value increases due to a climb in a share’s value. However, several other components also impact the share’s market value. Capital gains can usually result in significant returns but may also cause losses.
The second source of income for investors is the dividends they can get from the investment. These dividends stem from the company’s profits. For investors, a profitable company is a preferable investment over other options. The more profitable a company is, the more dividends it will pay. However, some people may confuse these dividends as a reduction in profit. Before clarifying the difference, it is crucial to understand what dividends are.
What are Dividends?
Dividends are a share in a company’s profits paid to shareholders. These payments may come directly from its profits during a year or from retained earnings. Usually, dividends come in the form of cash. But it may also cover share distribution or other benefits. Regardless of how investors get paid, dividends include any distribution of benefits to shareholders.
Companies usually pay dividends after every accounting period. For most companies, these payments will occur annually. Some companies may also distribute benefits to shareholders quarterly. However, some companies may choose not to pay dividends to shareholders and instead retain all profits. A company’s dividend retention policy will play a significant role in the dividends paid to shareholders.
Dividends do not entail any profits by companies. If a company decides to distribute those profits among shareholders, it will be considered a distribution. Therefore, it will become dividends. As mentioned, companies may choose not to distribute those profits. In that case, it will not be dividends. Instead, they will become a part of a company’s retained earnings.
The most common type of dividends paid to shareholders includes the distribution of cash dividends. These cash payments stem directly from a company’s cash reserves. Similarly, they will affect the company’s retained earnings. However, companies may also choose to distribute shares to shareholders. In those cases, it will impact a company’s share capital instead of its cash reserves.
Overall, when a company generates profits, it may choose to distribute it to shareholders. These profits stem from a company’s operations. However, shareholders can get a part of it known as dividends. For companies, these dividends do not represent an expense. Instead, it is a distribution of profits or retained earnings to shareholders.
How do Dividends work?
There are several ways in which dividends work. Typically, it starts when a company generates profits. As mentioned above, companies may decide to pay dividends based on the profit retention policy. Some companies may distribute some of these profits, while others may choose not to do so. If a company does not allocate dividends to shareholders, the process of distribution will not occur.
However, when companies choose to pay dividends, they will first decide how much it should be. As mentioned, the retention policy will play a role in it. However, there are other factors that will also affect how much dividends shareholders will get. The decision will depend on a company’s management team. Once it makes a decision, the company’s board will have to approve the planned dividends.
Once the board approves the planned dividends, the company will announce them. This announcement will include how much shareholders will get per share, the date for the distribution, the record date, etc. At the time of the distribution, the company will make the payments to shareholders. The company then reduces the total payment from its retained earnings account.
The process of dividend distribution is straightforward. Any shareholder that holds the company’s shares at the record date will receive their share. Any remaining profits get carried over to the retained earnings account. Usually, this account builds up and forms a company’s reserves. Some companies may also choose to distribute dividends from this account.
What reduces a company’s Profits?
Profits are any residual amount after reducing a company’s expenses from its income. In other words, it represents the difference between income and expenses. When a company’s expenses are lower than its income, then it will generate profits. However, it may also incur losses when the former outweighs the latter. There are several types of profits that companies can make.
The most critical profits for most investors are a company’s net profits. These entail all the returns that companies make. Similarly, investors may also prefer operating profits which are any returns from a company’s operations only. These profits are also usable in various ratios and financial metrics. Lastly, gross profits are any returns that companies make from their primary products or services.
The primary factor that impacts a company’s profits includes its expenses. The higher these are, the lower a company’s profits will be. However, the income that companies generate also impacts how much profits they make. The higher these are, the more profits companies will make. Therefore, a higher amount will be available for distribution to shareholders.
However, expenses are the only metrics that reduce a company’s profits. There are several types of these metrics that companies may have. Usually, companies categorize them based on their source and how they impact profits. These may include the cost of sales, cost of services, operating expenses, financial expenses, and other expenses.
Does a Dividend reduce Profits?
As mentioned above, dividends are not a company’s expenses. Instead, they entail the distribution of profits to shareholders. Since they are not expenses, they do not reduce or increase profits. However, they do have a relationship with these profits. Usually, the higher the profits are, the higher dividends a company’s shareholders will expect to receive.
When a company makes profits, they get transferred into the retained earnings account. However, when it pays dividends, these profits get reduced for transfer. The higher the dividends a company distributes, the lower its profits transferred to the retained earnings account balance will be. Companies use the following formula to calculate the retained earnings balance.
Retained Earnings = Opening Retained Earnings + Profits – Dividends
Therefore, a dividend distribution does not impact a company’s profits or reduce them. Instead, it lowers the amount that companies can transfer to the retained earnings account. Dividends also do not appear on the income statement. It is because dividends are a distribution of profits and not expenses. Therefore, they will not be a part of a company’s net profit calculation.
Overall, dividends do not reduce profits. When companies distribute profits among shareholders, the amount will impact the profits transferred to retained earnings. Companies do not report dividends in the income statement. Instead, they will be a part of the cash flow statement if they pay shareholders through cash reserves.
A company, ABC Co., generated a net profit of $10 million. The company’s retention ratio is 80%. Therefore, it will distribute the residual 20% to its shareholders, which will be $2 million. When the company reports its profits in the income statement, the net profits will still be $10 million. However, its retained earnings balance will not increase by $10 million.
Assuming ABC Co.’s retained earnings balance at the start of the year was $100 million, the closing balance will be as follows.
Retained Earnings = Opening Retained Earnings + Profits – Dividends
Retained Earnings = $100 million + $10 million – $2 million
Retained Earnings = $108 million
Due to the dividends paid, ABC Co.’s retained earnings account will only increase by $8 million. While these dividends impact the profits transferred to this account, they will not affect the net profits of ABC Co. Similarly, these dividends will not appear on the income statement. Assuming the company makes these distributions through cash reserves, the dividends will be a part of the cash flow statement.
Dividends involve the distribution of profits among shareholders. When companies distribute their earnings, they will not be an expense. Instead, these dividends will affect the profits transferred to the retained earnings account. Therefore, dividends do not reduce a company’s profits. It only impacts the balance sheet and cash flow statement.