Dividend vs keeping the profits in retained earnings
Should I pay a dividend from my company? When it comes to running a successful business, one of the most important decisions you’ll have to make is what to do with your profits. Should you pay a dividend to yourself as the business owner, or reinvest the money back into the company? It’s a question that many business owners struggle with, and there’s no one-size-fits-all answer.
We argue that paying dividends is a great way to reward the owners.
Others believe that reinvesting profits is the key to long-term growth and success. In this article, we’ll explore the pros and cons of both options, so you can make an informed decision that’s right for your business.
Understanding Dividends and How They Work
First, let’s define what a dividend is. A dividend is a payment made by a company to its shareholders, usually in the form of cash or additional shares or allocated to the loan account. Dividends are paid out of a company’s profits and are distributed on a regular basis, such as quarterly or annually.
There are different types of dividends, such as regular dividends, and special dividends.
Regular dividends are the most common type and are paid out on a regular basis. Special dividends are a one-time payment made by the company, usually when the company has extra profits. Stock dividends are paid in the form of additional shares of stock instead of cash.
Pros and Cons of Paying Dividends to Shareholders
Now that we know what dividends are, let’s explore the advantages and disadvantages of paying dividends to shareholders.
One of the main advantages of paying dividends is that it can be a great way to reward you as the owner. Shareholders receive a share of the company’s profits, and this can help to attract new investors and retain existing ones.
Importantly paying dividends reduces Retained Earnings. This reduction in retained earnings for a small business helps :
- The flow of profits for tax purposes
- The impact of holding too much capital that exposed if there is a legal claim against the company.
Disadvantages of Paying Dividends
One of the main disadvantages of paying dividends is that it can limit the company’s ability to reinvest in the business. When a company pays a dividend, it’s taking money out of the company that could be used to fund growth initiatives or invest in new projects. If the company doesn’t have enough cash to fund these initiatives, it may need to raise additional capital through debt or the owners lending money back
Another disadvantage of paying dividends is that it can create expectations among shareholders. If a company pays a dividend, shareholders may expect the company to continue paying dividends in the future.
Advantages and Disadvantages of Keeping Profits in the Company
Now, let’s explore the advantages and disadvantages of keeping profits in the company, rather than paying dividends.
Advantages of Keeping Profits in the Company
One of the main advantages of keeping profits in the company is that it allows the company to reinvest in the business. By reinvesting profits, the company can fund growth initiatives, invest in new projects, and improve its products or services. This can help to increase the value of the company over time and attract new investors.
Keeping profits in the company can also help to reduce the company’s reliance on external financing. If the company has enough cash to fund its growth initiatives, it may not need to raise additional capital through debt or equity financing. This can help to reduce the company’s debt load and improve its financial health.
Disadvantages of Keeping Profits in the Company
One of the main disadvantages of keeping profits in the company is that it can inhibit profit reward and extraction. If the company doesn’t pay a dividend, shareholders won’t receive a share of the profits in the short term.
As the owner this has 2 serious disadvantages
- NO reward in short term for your hard work
- Taxation – distributing in a regular method allow better tax planning
- Not declaring a divided but still taking the money may create a DIV 7a loan – not advisable
Another disadvantage of keeping profits in the company is that it can create excess cash that isn’t being used effectively. A business owner should have a clear plan for how to reinvest its profits. If not, it may be better to distribute the profits to shareholders in the form of a dividend.
Finally take profits as you go and dont leave it for someone else if something goes wrong ie liquidation or legal action . Paying out dividends is like passing the gate way of no return. Be careful though as declaring a dividend with poor trading can lead to insolvent trading!
Criteria for Deciding Whether to Pay Dividends or Keep Profits
Let’s look at some criteria for deciding which option is best for your business.
Analyzing the Financial Health of the Company
One important criterion for deciding whether to pay dividends or keep profits in the company is the financial health of the business. If the company is financially stable and has excess cash, it may be a good idea to pay a dividend. However, if the company is in a growth phase and needs to reinvest profits to fund growth initiatives, it may be better to keep the profits in the company.
Considering the Company’s Growth Potential
Another important criterion is the company’s growth potential. If the company has a high growth potential, it may be better to reinvest profits in the business. Thereby funding growth. However, if the company doesn’t have many growth opportunities, it may be better to pay a dividend . Reward shareholders and extract the excess cash from the business.
Evaluating the Shareholder’s Preferences
Finally, it’s important to consider the preferences of the company’s shareholders. Some shareholders may prefer to receive a dividend, yet the other business owner may prefer to see the company reinvest profits in the business. It’s important to understand the preferences of the company’s shareholders and make a decision that’s in their best interests.
Look at the Franking account as a small business and see how this may impact your future tax liability personally. Remember declaring a franked dividend have credits attached. However, while tax is paid with the lowering of the company tax rate there may be top-up tax payable
Top-up tax is effectively the shortfall of tax that may be incurred in the event that a shareholder is on a higher tax rate ie tax credits typically for small business is @ 25% but you may have taxpayers on higher rates such as 32.5% and beyond
Conclusion and Final Thoughts on the Dividend vs. Profit Debate
In conclusion, the decision to pay a dividend or keep profits in the company is a complex one that requires careful consideration of the company’s financial health, growth potential, and shareholder preferences. While paying dividends can be a great way to reward shareholders and attract new investors, reinvesting profits can be the key to long-term growth and success. Ultimately, the decision will depend on the unique circumstances of each business. By weighing the pros and cons of each option and considering the criteria outlined in this article, business owners can make an informed decision that’s right for their company.