When you speak about a company that is not making a profit, you need to understand that there could be a variety of reasons for this. Maybe the company is in trouble and they are simply not making enough money to generate a profit. Or maybe, they are busy reinvesting money into the company in which case it will realise profits eventually. For both cases, can dividends be distributed without profit?
The most common way in which a company pays dividends even when it is not making a profit is by using retained earnings from previous years. The company can also use capital profit which are obtained by the selling of assets at a higher price than what they bought them for.
The fact that you are asking questions like these leads me to believe that you are starting to get a good understanding of how the market works. Basically, it is a very technical question that requires an in-depth discussion. In this article, we are going to cover everything that you need to know. So, I highly recommend that you keep reading on.
How Companies can Pay Dividends Without Making a Profit
Whether or not a company can pay dividends without realising a profit depends entirely on the company and its success over the last few years.
A company can use profits from previous years to continue paying dividends to its shareholders. There are reasons for why they do this which we will take a look at in a short while.
There are also a few other ways that they can pay dividends without making a profit. Let’s start by making a list and then taking a deep look into each of these reasons.
- Using retained funds
- Selling assets
- Selling shares
#1. Using Retained Earnings
When you invest, you do your research and you should know the financial stability of a company before buying shares. You should also know as much about their financials from their previous years as you can.
This is because, if a company that offers a dividend is not realising profit yet they may have had a few successful years where they managed to secure large profit, and have since saved this capital to pay future dividends.
The company has a few choices when it comes to what they should do with their profits. After all expenses, they can pay 100% of what’s left to their shareholders. They could also choose to keep some of that money as reserves or savings. This is what is known as a Dividend Payout Ratio, it is the proportion of profits that are paid out. And bigger is not always better!
There is also another thing that a lot of companies choose to do which is to use a portion of the profits to reinvest into the company for new projects or expansion of their operations.
They could do all three of these things at the same time which is why it is rare for a successful company to pay 100% of their profits out as dividends.
If a company is not profitable for a year it is not necessarily always a bad thing. It could be that they are spending more money to expand their operations and therefore, it is at this time that they will dig into the reserve to pay out the dividend.
#2. The Selling Of Assets
We have written a recent article about capital profit. Basically, the gist of the article is that a company can use its capital profit to pay out dividends.
Capital profit is when a company sells off its assets such as property or equipment. The company can then use a portion of that money to pay out dividends.
It is important to remember that a company can also use its capital profit to reinvest in other areas of the business which is good for the long run. This might also affect whether or not you receive a dividend for that period.
Capital profit gained from the selling of assets does not count as revenue profit. This is very important to remember. So, technically the books can still say that the company ran at a loss for the year because they did not gain profit from their regular business activities. However, they still have cash equity from the sale of assets, which they can use to keep shareholders happy.
#3. Raising Money Through The Sale Of Shares
This can also be considered capital profit however, it is very technical to determine what a profit is when it comes to the sale of shares.
Most commonly, if a company manages to sell shares at a higher value than what the share is worth then the surplus will be counted as capital profit and a company can use that to pay out dividends.
For example: If a company issues shares at the current price of $50 per share, then the share price shoots up to $60 per share. Every share sold at the higher price is classed as a capital profit from the sale of shares.
Much like with the selling of assets, this money can be used to invest in the company or can be used to pay out dividends. It all depends on the company.
Again, this does not count as revenue profit because the profit does not come from regular business activities.
What If There Are Insufficient Funds For Dividends?
At some point it becomes unlawful for a company to pay out dividends if the company is not making any profit. With that being said, it becomes extremely difficult to prove that the company is paying out more dividends than what they are making.
I know it sounds a little off. After all, how can a company pay dividends when it doesn’t have money? Well, just because a company is running at a loss doesn’t mean they don’t have cash flow.
A company could base its dividend payout based on its current bank balance rather than profit. This can significantly have an impact on taxation. If all dividends paid are capital dividends, in the USA this kind of income is tax free, which as you will understand… The IRS will not enjoy.
If there are insufficient funds to pay dividends, either the company will cut the percentage, issue a dividend holiday, or cut the dividend completely. In some cases, a company will hold dividend payments and offer to pay more in future years to offset the lost income for investors. Find out if your dividend is safe here!
Can Dividend Payments be More than Profit?
Although this question is similar to the title of this article, it does differ enough for us to take a look at it. The answer, however, is almost identical to the answer to the main title of this article.
Dividends can exceed profits because the company can use retained profits from previous years to continue paying out dividends. This will be identified as a dividend payout ratio of over 100%.
There is a difference between revenue profit and capital profit and if a company chooses to use its capital profit to pay out dividends then you could be receiving dividends that are higher than what your earnings per share should be.
So, to summarise this section, a company can pay a higher earning per share than what they should have based on their revenue profit if they decided to include capital profit in the dividend payment or if they use retained earnings to increase the payment. This is all about keeping shareholders happy.
Final Thoughts And Examples
Investing can be tricky. Sometimes data can misrepresent a company’s present financial stability. That is why you should always look into how the company has done over the last decade at least. Let’s take Microsoft as an example as it is a highly profitable company.
Let’s say Microsoft decides to heavily invest in new technology such as the upcoming “Microsoft Mesh”, please note that this is just an example. Let’s say Microsoft wants Microsoft Mesh to become the new phenomenon of the current decade and they invest almost all their profits into the technology.
So, for the next year, they don’t report any profit but they still want to keep the shareholders happy. They will use previous earnings that they have retained to continue paying their investors as per the value of their shares.
They can do this knowing that with the new upcoming technology, they expect to increase their profits over the next few years. Remember, investing is long-term and should almost always be seen as such.