Dividends and retained earnings. Two accounts that surprisingly get misunderstood a lot by financial report users.
How come?
Well, folks often think dividends are a company's expenses, and retained earnings are just cold, hard cash.
Isn't that how it works?
Nah, that's way off.
Alright, since this seems to be a head-scratcher for many, let me break it down.
Table of Contents
Understanding Dividends from P&L Statements
First off, dividends. Ever seen a profit and loss statement listing dividend expenses?
Doubt it. So, in a profit and loss statement, you usually see the cost of goods sold, made up of direct labor, raw materials, and overhead costs.
Beyond that, there are other expenses like administrative and sales costs. Oops, scratch that... not costs, but administrative and sales expenses.
According to Wall Street Mojo, the key difference between Cost and Expense is that cost refers to the amount spent by the business organization to acquire an asset or to create the assets. In contrast, the expense refers to the amount spent by the business organization for the ongoing operations of the business to ensure revenue generation. [1]
So, besides the cost of goods sold and administrative and sales expenses, what else is there? Interest expenses. Interest expenses represent the company's capital costs from issuing bonds or other loans.
Hold up, are you saying dividends are expenses on the income statement? Like, they're just as burdensome as interest expenses, both chipping away at the company's capital costs, right?
Unfortunately, that's not true.
But why not? Interest expenses or debt capital costs are considered expenses, right? So, dividends should also be expenses, right? I mean, dividends are equity capital costs from issuing stocks.
Remember this carefully. Profit and loss statements don't categorize equity capital costs as expenses.
Unveiling the Truth About Dividends
Remember where dividends come from? Retained earnings.
And where do retained earnings come from? Net profit.
So, dividends are essentially from net profit. Net profit is the company's bottom line! The final calculation on the profit and loss statement.
Net profit is sales revenue minus all costs and expenses.
That's why dividends aren't classified as costs or expenses in the profit and loss statement.
To classify a transaction as a cost or expense, it must reduce the company's revenue to be presented as net profit.
But dividends don't do that.
So, clearly, dividends aren't company expenses because they don't reduce revenue/sales to determine net profit. Instead, dividends are distributions of net profit itself.
Financial Policy Navigation for Retained Earnings and Dividends
Now, let's talk about retained earnings not necessarily being in cash form.
As I mentioned earlier, net profit is distributed as dividends. But there's also a portion of net profit not distributed as dividends, which is retained earnings.
Every company has its own policy regarding dividend distribution and retention ratio.
Speaking of dividend distribution size, it's called the Dividend Payout Ratio. According to Yield Street, The Dividend Payout Ratio (DPR) is the amount of dividends paid to shareholders in relation to the total amount of net income the company generates. [2]
Now, about the retention ratio itself, according to Investopedia, The retention ratio is the proportion of earnings kept back in the business as retained earnings. [3]
The formula for the retention ratio is (net profit - dividend distribution) divided by net profit. And as for the dividend payout ratio, it's dividend paid divided by net profit.
So, these two ratios are related because both are proportions of net profit distribution.
Some companies decide to retain 50% of net profit, distributing the remaining 50% as dividends. Others might retain 70% of net profit, distributing the rest as dividends.
It all depends on each company. Mature companies usually distribute a larger portion as dividends compared to retained earnings. Conversely, companies in the expansion phase tend to retain a much larger portion of profits than dividend distribution because they need a lot of cash for expansion.
Redefining Retained Earnings
Now back to the misunderstanding about retained earnings, where many think it's in cash form.
Not necessarily!!
Think about it, is net profit always in cash form? Nope.
With accrual accounting, a company can recognize revenue even if cash hasn't been received. So, net profit itself isn't always cash.
And it's possible that the retained earnings have already been used to fund company operations, such as buying inventory or financing investments in fixed assets like machinery or setting up factories.
So, don't be surprised if you see a significant amount of retained earnings on a company's balance sheet, possibly much larger than the company's cash at that time. It doesn't mean there's fraud or accounting errors. It's just a normal thing because retained earnings aren't always in cash.
A Final Word of Advice
Let's cut the theatrics of blaming dividend expenses for the dip in net profit.
Let's quit asking why I don't have as much cash as my retained earnings.
And here's a friendly reminder from yours truly: as you venture into the world of business, make sure you're well-versed in the nitty-gritty of accounting and finance. No surprises allowed, no room for games.
ARTICLE SOURCES
- Cost vs Expense. Wall Street Mojo. https://www.wallstreetmojo.com/cost-vs-expense/. (accessed April 7, 2024)
- Dividend Payout Ratio 101: What Every Investor Should Know. https://www.yieldstreet.com/blog/article/dividend-payout-ratio-101/. (accessed April 7, 2024)
- Retention Ratio: Definition, Formula, Limitations, and Example. Investopedia. By Chris B. Murphy. https://www.investopedia.com/terms/r/retentionratio.asp. (accessed April 7, 2024)
