Understanding when a company can't make a dividend payment can be crucial at times of financial stress.
Many investors rely on dividends from their investments to provide much-needed income. But companies aren't always allowed to continue making dividend payments. If a company no longer has any retained earnings on its balance sheet, then it typically can't pay dividends except in extraordinary circ*mstances.
What retained earnings are
Retained earnings represent the accumulated earnings from a company since its formation. Most companies lose money when they first start up, and so for a time, their retained earnings will be negative. That's one reason why most start-ups don't pay dividends, in addition to the fact that new companies generally need to hold onto any cash they have to grow their business.
Once a company starts making money, then its retained earnings start to rise. Once the company has made up for any earlier losses, a positive balance in its retained earnings will allow it to pay dividends if it chooses.
Why companies can pay dividends even when they're losing money
Many investors find it confusing that a company can pay a dividend even when it's losing money. The reason is that when a company retains earnings from previous profitable periods, it effectively reserves the right to pay them out to shareholders as dividends in the future. Therefore, most dividend-paying stocks don't have to suspend their dividends when they hit a temporary setback that causes them to lose money, because they've already built up a reserve of retained earnings to draw from.
Of course, just because a company can pay dividends doesn't mean it always will. The company won't always have actual cash to pay a dividend, even if the retained earnings line item on its balance sheet is positive. Still, some companies will borrow money specifically to pay a dividend during times of financial stress.
Finally, there is one situation in which a company can pay a dividend even with negative retained earnings. If the company is wrapping up its operations, then it can make dissolution or liquidation dividend payments to shareholders regardless of the condition of its balance sheet.
Still, in the vast majority of cases, companies can't pay dividends that exceed their retained earnings. Dividend investors should therefore keep an eye on the balance sheets of the companies whose stock they own to get an early warning of any potential problem with paying dividends in the future.
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FAQs
If the company is wrapping up its operations, then it can make dissolution or liquidation dividend payments to shareholders regardless of the condition of its balance sheet. Still, in the vast majority of cases, companies can't pay dividends that exceed their retained earnings.
Can I pay dividends out of retained earnings? ›
There's no limit, and no set amount – you might even pay your shareholders different dividend amounts. Dividends are paid from a company's profits, so payments might fluctuate depending on how much profit is available. If the company doesn't have any retained profit, it can't make dividend payments.
Can dividends exceed earnings? ›
Declaring and paying dividends has nothing directly to do with current earnings per share (EPS). Companies can pay a dividend per share that exceeds its EPS.
Can the all amount in the retained earnings be usually used to pay dividends? ›
Retained earnings are the portion of a company's cumulative profit that is held or retained and saved for future use. Retained earnings could be used for funding an expansion or paying dividends to shareholders at a later date.
Can you distribute more dividends than retained earnings? ›
In most cases, no, a company can't pay more dividends than it has in profits.
What is the dividend trap? ›
A dividend trap is where the stock's dividend and price decrease over time due to high payout ratios, high levels of debt, or the difference between profits and cash. These situations commonly produce an unsupported but attractive yield.
What are the rules for dividend payments? ›
Final dividends require shareholder approval; interim dividends do not. The company has sufficient funds to pay the dividends. Before paying dividends, the company must have enough cash or liquid assets to cover the payments, and the directors must judge that the payment will not cause cash flow problems.
Do you debit retained earnings when paying dividends? ›
On the initial date when a dividend to shareholders is formally declared, the company's retained earnings account is debited for the dividend amount while the dividends payable account is credited by the same amount. Retained Earnings → Debited [Dr.] Dividends Payable → Credited [Cr.]
Should dividends be closed to retained earnings? ›
Dividends are closed directly to retained earnings. The retained earnings account is reduced by the amount paid out in dividends through a debit and the dividends expense is credited.
What is the nimble dividend rule? ›
Nimble Dividend Rule
This is designed to prevent a company from using prior year E&P deficits to offset the amount included as a dividend. The nimble dividend rule is of particular importance for investors in areas such as infrastructure investments, which may have long periods of deficits before becoming profitable.
Dividends. A dividend is a payment a company can make to shareholders if it has made a profit. You cannot count dividends as business costs when you work out your Corporation Tax. Your company must not pay out more in dividends than its available profits from current and previous financial years.
What is the nimble dividend test? ›
A nimble dividend occurs when an entity has current earnings and profits but it remains in an overall accumulated deficit at year end. The nimble dividend rule requires the dividend to come first out of current E&P, which prevents using prior deficits to offset the amount included as a dividend.
Can you take money out of retained earnings? ›
Retained earnings can be paid out as dividends, which have different tax implications that will affect the tax consequences and results of this strategy.
What is the correct balance between dividends and retained earnings? ›
At the end of each accounting period, retained earnings are reported on the balance sheet as the accumulated income from the prior year (including the current year's income), minus dividends paid to shareholders.
How much should you keep in retained earnings? ›
If your business is debt-free: Put about 50% of your monthly profits into retained earnings until you reach six months of operating capital.
Can dividends be paid out of accumulated profits? ›
Legal Provisions relating to Dividend
Section 123(1) of the Act inter-alia states that “no dividend shall be declared or paid by a company for any financial year except out of the profits of the company for that year or out of the profits of the company for any previous financial years”.
How does paying dividends affect retained earnings? ›
Cash dividends affect the cash and shareholder equity on the balance sheet; retained earnings and cash are reduced by the total value of the dividend. Stock dividends have no impact on the cash position of a company and only impact the shareholders equity section of the balance sheet.
Can you pay dividends out of reserves? ›
On the balance sheet, there needs to be a healthy figure under 'retained earnings' or 'profit and loss reserves'. For micro-entities, funds available to pay dividends are found under 'capital and reserves'.
When not to pay a dividend? ›
Reason 1: Financial Trouble
The chief cause of a dividend suspension is the issuing company is under financial strain. Because dividends are issued to shareholders out of a company's retained earnings, a struggling company may choose to suspend dividend payments to safeguard its financial reserves for future expenses.
