Dividends are a key feature of the way limited companies do business, but they can be a little bit confusing on the surface.

To help make things nice and simple, this article will cover the basics that every limited company director should know about dividends, including:

  • Definition: What are dividends?
  • The different kinds of dividends.
  • The advantages of dividends.
  • The challenges with dividends. 

Definition: What are dividends?

When a public company is limited by shares, it means they can sell shares in their business to inventors. Those investors then become shareholders. Then, if the company makes a profit, it can distribute some of the profits to its shareholders through dividend payments. 

The size of the payment depends on how much stock a shareholder owns and the dividend rate set by the company directors. 

The price of the company’s shares on the stock market doesn’t necessarily affect dividend payments, it’s just an amount decided by the company owners, and agreed upon by shareholders. 

That said, the dividend amount will normally increase with profits so that shareholders have a reason to stay invested. 

Main types of dividends

When it comes to dividend payments, there are a few different kinds that company directors can give shareholders. 

Cash dividends

Cash dividends are paid directly into a shareholder’s brokerage account at the end of an accounting period (for example, every quarter, or every year). This is the most common kind of dividend payment.

Stock dividends

As well as cash payments, company directors can also use stock to make dividend payments. Paying shareholders in stock dividends means they own more of the company. They’ll receive more dividends over time and they don’t have to pay Income Tax on them. 

Special dividends 

Finally, there are special dividends. These are a kind of added bonus for shareholders. They’re normally taken from excess cash that a company has no real need for. 

For example, if your company has accumulated profits over time, you can pay your shareholders a special dividend as a show of good faith and appreciation for their long-term investment. 

Advantages

Incentives 

As a company director, dividends are a strong incentive for investors, and stable investment will ensure your long-term stability. This is because Companies that consistently pay out dividends attract more investors and keep the ones they already have. 

Taxes

Shareholders of a company (including yourself) don’t have to pay tax on income from dividends that fall within the Personal Tax-Free Allowance (£12,570). On top of that, there’s also a Dividend Allowance of £2,000.

Shareholders only start paying tax on dividends after they’ve used up the Personal Allowance and the tax-free Dividend Allowance. If the allowances are used, then dividends are taxed like this:

  • Basic-rate taxpayers pay 7.5%
  • Higher-rate taxpayers pay 32.5%
  • Additional-rate taxpayers pay 38.1%.

As the company director, this is great news because you can subsidise part of your salary with dividends, meaning you’ll be taxed less than if you were to take out the entire amount as a salary. 

Challenges

Before deciding to buy shares, investors will want some assurance that there’s a good chance of making a return on their investment. 

Because dividends are based on profits, one of the biggest challenges is predicting the amount of profit you can expect. The prediction will have a direct impact on the amount of dividends you pay to your shareholders, as well as an effect on potential future investors. 

In order to predict a company’s performance over time, most people use the weighted average cost of capital (WACC) formula. 

The formula looks like this:

WACC = (E/V x Re) + ((D/V x Rd) x (1-T))

In this formula, the letters stand for:

E = Market value of the business’s equity

V = Total value of capital (equity + debt)

Re = Cost of equity

D = Market value of the business’ debt

Rd = Cost of debt

T = Tax rate

The WACC formula will give you a percentage, showing how much money will be produced by your company compared to how much money it spends. 

Here’s a rundown of each part of the formula. 

Market value of the business’ equity (E)

The market value of equity is the company’s current stock price multiplied by the total number of shares. 

Total value of capital (V)

The total value of a company’s assets and money. You’ll get this by deducting the market value of the company’s debt from the market value of its equity.

Cost of equity (Re)

The cost of equity is basically the price that shareholders are willing to pay in order to take the risk of buying shares in a company. 

Market value of the business’ debt (D)

The total amount of debt a company has, including the debt that isn’t reported in their books (like bank debt). 

Cost of debt (Rd)

To calculate the cost of debt, you use the market interest rate (standard interest rate in the market) or the actual interest rate the company currently pays on its debt.

Tax rate (T)

This one is fairly simple. For limited companies, just use the corporation tax rate – 19%. 

Measure your company profits with accounting software

Dividend payments rely on your profits, and predicting your profits is much easier with the Countingup app’s profit and loss insights.

Countingup is the business current account with built-in accounting software that allows you to manage all your financial data in one place. With features like automatic expense categorisation, invoicing on the go, receipt capture tools, tax estimates, and cash flow insights, you can confidently keep on top of your business finances wherever you are. 

You can also share your bookkeeping with your accountant instantly without worrying about duplication errors, data lags or inaccuracies. Seamless, simple, and straightforward! 

Find out more here.

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