When you invest your money, you want to make sure that you know as much as possible and this is one of the best questions I have had in a long time. Can you receive dividends from capital profits this is a tricky question but we will do our best to answer it.
A company can pay you your dividends from capital profits. In fact, most companies do this. Capital profit can come in a variety of ways. The most common of these is through the sale and issuing of shares and also the selling of assets such as property and equipment.
Capital profit can be significant, or it can also be small if a company does not sell a lot of assets or securities. In this article, we are going to take an in-depth look at all of this. We are also going to discuss a few misconceptions that some people might have. So, for everything you need to know about dividends and capital profits, keep reading.
Can Dividends be Paid from Capital Reserve Profits?
The capital reserve of a company is an asset. In fact, it is the most liquid asset that a company can have. A reserve, which is usually cash, can generate profit in a few ways. The most common of these is through interest. Think of the reserve as a savings account. This account should generate interest.
You might think that a company will hold its reserves in the bank that offers them the most interest.
This is not always true. A bank might offer a company certain perks that outweigh the interest that they receive on their reserve account. So, depending on the bank and the company, this interest can be small or it can be significant.
A company can include profits from the cash reserves when they pay out their dividends. The company can also dig into its reserves when it needs to pay dividends, if they do not have the cash flow to sustain the payments to investors. Although this should raise a few eyebrows as to why they need to do this.
It could be just a cash flow problem however the company could still be making a profit. Alternatively, the company could be in trouble. With that being said, it wouldn’t be allowed to pay you out of the reserves unless they were making a profit because this is illegal.
It is illegal for any company to pay dividends that are more than their profit. The reason for this is because it could create loopholes where people could evade tax. However, a company can hold back profits from prior years to pay investors. This is done regularly by growing companies.
Using the Previous Year’s Profit to Pay Dividends
So, as we discussed, it is illegal for a company to pay more dividends than what they are making in profit. However, if a company is struggling they can use last year’s profits to pay dividends. A lot of this profit will often be in the cash reserve.
This is another way that you can get paid from the capital reserves a company holds.
Understanding Capital Profits
For those of you that have a full understanding of capital profits, feel free to skip this section. If you want to learn more, keep reading. Capital profit is what it sounds like, although I do understand that a lot of people might not fully understand what it means.
Capital profits do not come from the regular business activities of a company. They come from the liquidation of assets, sale of assets through the year, or the issuing of new shares to investors. It has nothing to do with the regular revenue of the company. This is the most important thing to understand.
With all of that said, how does this work exactly? Well, let’s take a quick look. We will break this down into 3 sections.
#1. Capital Profits From Liquidation
If a company gets liquidated and they own assets to the value of $5 million and its liabilities come to $1 million, that means that the shareholder equity is $4 million. This will be paid out to shareholders.
#2. Capital Profits From The Selling Of Assets
If a company owns lots of machinery that they use to conduct business activity and they decide to sell it and buy different equipment, that would be “selling an asset”. If they sell the machinery for more than what they bought it for that means they made a profit from their initial capital.
We use machinery as an example as it is the easiest to understand. However, capital profits can come from selling any type of asset that the company owns including vehicles, furniture, or property, and things like that.
#3. Capital Profits From Issuing Shares
This is where things start to get a lot more complicated.
If a company manages to sell shares at a higher price than what they are valued at, this is considered capital profit.
If the current share price of the company is $50 per share, and the company issues new shares at $55 per share. For each share sold at the higher price, it is a $5 capital profit. When you multiply that by a massive scale, you start to see significant capital profits.
The in’s and out’s of issuing new shares is a headache, but in simple terms, if a company decided to issue new shares at the current share price… Then the share price jumps, every share sold after the jump in price is bringing in a profit. The opposite is true if the share price slumps after the issue.
The Difference Between Revenue Profit And Capital Profits
Again this is a subject that I think a lot of people will understand but if you don’t, there is no need to worry as we are going to cover it in this section.
- Revenue profit is profit from normal business activities. So, if a business delivers a service, the profit will come from delivering that service. Likewise, if the company is selling something then the revenue profit comes from the sales of those goods.
- Now on to capital profits. As we have discussed, capital profit does not come from normal business activities. Instead, capital profit comes from profit obtained from selling assets or securities.
The Difference Between Regular Dividends And Capital Dividends
I feel like this is very important to cover in this article because I am sure that a lot of people might confuse capital dividends with regular dividends. These things sound similar but are not.
When you invest, you can think of it as giving the company capital and hoping that they use that capital to create more profit.
Some companies might pay you capital dividends which is basically just giving you back your initial investment before paying any returns or losses. Why would this be done and what are the benefits of it?
You do not pay tax on your capital dividends. Once your initial investment has been repaid via capital dividends, you pay capital gains tax on the full sale price of your shares. This makes life easier for a lot of investors that are high income taxpayers in the larger tax bands. This is similar to bonds and taxation of those assets.
That pretty much sums everything up. If you have any further questions about investing, feel free to take a look at some of our other articles. We try and cover as much as possible in the simplest way that we can.
I think we did a pretty good job of explaining capital profits and dividends as best we could. It is always going to be a tricky subject and you will find a lot of varying answers when doing your research. So, things might seem unclear in the beginning. But it all comes down to this: Capital profits are profits that are earned via assets instead of the regular business activities.