If you take a look at the bottom of your company’s balance sheet, you’ll notice a figure called ‘retained earnings’ (RE).
RE represents all of the profits (after tax) your company has ever made, less all of the dividends it has ever declared. In other words, it shows show much of your all-time profits have been retained within the company as opposed to being taken out by the shareholders.
RE is important as it determines the maximum amount of dividend that a company can declare. Dividends, under company law, can only be declared out of ‘distributable profits’ which, for most companies means RE. a dividend in excess of RE is an illegal dividend.
Ideally, each year, your company’s RE should improve. If you take a look at your last balance sheet, you’ll notice that, if you add the RE to your share capital, the number you get is the same as the ‘net assets’ of the company (which will be shown halfway down your balance sheet). So, if you can generate more profit and take less dividend, your RE will improve and, at the same time, your company’s net asset position will improve too. This is a positive if you’re looking to improve the company’s credit score and impress readers of the accounts. They can see that you’re not ‘bleeding’ the company of profits.
So, based on the assumption that your company will generate a profit after tax of say £100k for the year, how much dividend should be declared? Ideally, it will be less than £100k so as to allow your RE (and therefore net assets) to grow. In theory, however, the dividend could be more than £100k as long as the RE (prom prior years) is there to cover the dividend. You take your RE brought forward from last year, add profit after tax for the current year and see how much is available. Then deduct this year’s dividend and that will be the RE carried forward to next year.
Ideally, you won’t use RE brought forward though – you’ll restrict the dividend to a percentage of the current year’s profit after tax. This percentage is known as the dividend payout ratio. Let’s say you choose to restrict annual dividends to 70% of profit after tax for the year. In our example above, you’d declare a dividend of £70k for the year on the £100k profit and allow RE and net assets to grow by £30k.
Whilst a dividend payout ratio of 70% might be considered reasonable for many SME companies (even higher in many cases), the average dividend payout ratio is likely to vary dramatically depending on the company’s priorities and circumstances. Companies in a high-growth phase are likely to retain most of their profits for reinvestment in the business, so payout ratios will be minimal. Non-growth companies will tend to have higher ratios.
Many shareholders of SME companies are also directors and choose to take their income as dividends rather than salary for tax purposes. This somewhat clouds the position regarding dividend payout ratios. If you think about a larger company, with directors on market salaries, the dividends declared each year will be more of a genuine reward for investors. In small SME companies, the dividends tend to be more of ‘disguised’ directors’ salaries, so dividend payout ratios do tend to be higher – to cover the ‘remuneration’ requirement of the shareholders/directors.
But, even for SMEs, the trend of an increasing dividend payout ratio is a cause for concern, in that it may well demonstrate that the shareholders are taking too much of the annual profit for themselves, rather than leaving it in the company for investment and working capital needs.
