Understanding Dividend

By Fazila Khan 15 Minutes Read

Introduction

Dividends are like a slice of a company’s profits handed out to its shareholders. When a company makes money, it can decide to share a portion of those earnings with its shareholders. These payments often happen every three months and are usually given in cash. So, if you own shares in a company, dividends are your way of getting a piece of their profits. Sometimes, instead of cash, companies might give out more shares or other valuable stuff. For investors, especially those looking for regular income from their investments, dividends are a key thing to think about when choosing which stocks to buy.

Businesses aim to make profits and distribute them among owners, known as dividends in the case of companies under the Companies Act, 2013. A dividend is a company’s way of rewarding shareholders for their investment. It represents a share of the profits distributed to shareholders after the company finalizes its financial accounts.

Meaning

The term ‘dividend’ is derived from the Latin word ‘dividendum’ meaning ‘that which is to be divided.’ It represents the portion of a company’s profits that is distributed among its shareholders. Unlike interest, which arises from contractual obligations, dividends are paid out of profits and involve the actual distribution of assets. However, issuing bonus shares or rights shares to existing shareholders does not qualify as dividends because the former does not involve releasing assets and the latter is not tied to the company’s profits.

According to Section 2(35) of the Companies Act, 2013, “dividend” includes interim dividends and is distributed based on the number of shares held by each shareholder, as authorized by the company’s Articles of Association (Section 51, Companies Act).

Every trading company inherently possesses the authority to distribute its net earnings or profits to shareholders in the form of dividends, even if this authority is not explicitly stated in its Memorandum or Articles of Association. However, Articles of Association may regulate the manner in which dividends are to be paid.

Dividends can only be declared from the company’s net profits as determined for financial statements, following Section 129 of the Act and applicable accounting standards under Section 133. Chapter VIII of the Act governs the declaration and payment of dividends, aligning mostly with the provisions of the Companies Act, 1956.

With the exception of Non-Profit Organizations registered under Section 8, all companies have the authority to declare dividends. Further, Sections 123 to 127 of Chapter VIII in the Companies Act outline the procedures for declaring and paying dividends.

Types of Dividends

Dividends are the distributions of a company’s earnings to its shareholders, typically paid in cash or stock. There are several types of dividends that companies may issue. These types of dividends provide companies flexibility in how they distribute earnings to shareholders, allowing them to manage cash flow, retain capital, or reward shareholders based on their financial strategies and performance. Some kinds of dividends that a company may issue are:

• Cash Dividend: This is the most common type, where shareholders receive a portion of the company’s profits in the form of cash payments. Cash dividends are usually paid on a per-share basis, such as “$1.00 per share.”
• Stock Dividend: Instead of cash, companies may issue additional shares of stock to shareholders. These are proportional to the shares already owned, so if you own 100 shares and receive a 10% stock dividend, you will receive an additional 10 shares.
• Property Dividend: Sometimes companies distribute assets other than cash or stock, such as bonds, inventory, or other property, as dividends.
• Scrip Dividend: This is similar to a stock dividend but involves issuing certificates that entitle shareholders to additional shares at a later date, rather than immediate issuance.
• Special Dividend: This is an extra dividend paid outside of the regular schedule. It’s usually a one-time payment and is often declared when a company has exceptionally strong earnings or excess cash.
• Interim Dividend: These dividends are paid before a company has determined its final profits for the year. They are typically declared and paid during the fiscal year, before the annual financial statements are completed.
• Liquidating Dividend: When a company is winding up its operations and liquidating its assets, it may distribute the proceeds to shareholders as liquidating dividends.
• Final Dividend: A final dividend refers to the dividend declared by a company at the end of its financial year, after the determination of its annual profits.

Key dates related to Dividend

Understanding the key dates related to dividends is essential for investors to effectively manage their investment strategies. These dates play a crucial role in determining when shareholders qualify to receive dividends from the companies they have invested in. By staying informed about these key dates, investors can plan ahead and make well-informed decisions about their investments. Here is a breakdown of these important dates:

• Declaration/ announcement date: This is when a company publicly announces its plan to distribute a dividend. It includes details such as the amount per share and the scheduled payment date.

• Ex- dividend date: Shareholders must own the stock before this date to be eligible for the upcoming dividend payment. Purchasing shares on or after this date means the buyer will not receive the current dividend.

• Record date: This is the date on which a company determines the list of shareholders who qualify to receive the dividend. Shareholders who are registered on this date are entitled to the dividend payout

• Payment date: This is the actual date when the dividend is distributed to eligible shareholders. It typically occurs several weeks after the record date.

For Instance:

A company XYZ corporation announces their intention to pay a $0.50 per share dividend on February 20, 2024. To receive this dividend, investors must buy the stock before the ex-dividend date of March 13, 2024. Those who purchase the stock on or after this date will not receive the dividend. The record date is March 15, 2024, and only shareholders on record by then will receive the payment. The payment date is March 18th, 2024, shareholders who were recorded as owning XYZ Corporation’s shares on the record date will receive $0.50 per share in their accounts on this date.

Legal provisions related to Dividend

The Companies Act, 2013 provides legal provisions related to dividends to ensure proper governance and protection of shareholders’ interests. These provisions aim to ensure transparency, fairness, and accountability in the distribution of profits to shareholders, while also protecting the financial health and sustainability of the company. They provide a legal framework for dividend payments that balances the interests of shareholders with the company’s need for financial prudence and compliance. Some key provisions related to dividends under the Companies Act, 2013 are:

• Definition of Dividend: According to Section 2(35) of the Act, “dividend” includes any interim dividend, which is a payment made by a company to its shareholders.

• Source of Dividends:  Section 123(1) of the Act states that dividends can only be declared or paid out of profits earned during the current financial year or in previous financial years. This ensures dividends are funded by actual profits, not borrowed money or unrealized gains.

The case of Hutton v West Cork Railway Co.[1]  established a fundamental rule in corporate law regarding dividends. It clarified that dividends must be paid out of a company’s profits rather than its capital. This legal decision ensured that shareholders receive distributions that accurately reflect the company’s financial earnings and health, promoting transparency and responsible financial management.

• Exclusions from Profits: The law clarifies that when calculating profits available for dividends (under Section 123(1)(a)), unrealized gains, notional gains, and changes in the value of assets or liabilities measured at fair value should not be included.

• Dividends from Free Reserves: If a company lacks sufficient profits in a given year, it can propose to pay dividends from its accumulated free reserves (profits set aside from previous years). This proposal must comply with specific restrictions outlined in Rule 3 of the Companies (Declaration and Payment of Dividend) Rules, 2014.

• Interim Dividends: Section 123(3) deals specifically with interim dividends, which are dividends declared and paid during the financial year before the finalization of annual financial statements. Unlike final dividends, interim dividends do not require the company to have free reserves; they are typically paid out of profits from the current financial year.

As in the case of, Hogg v. Cramphorn Ltd[2], it was decided that directors can decide to give out dividends, including interim dividends. However, they must do this while following their legal responsibilities under company law. 

• Board Approval v/s Shareholder Approval: Interim dividends can be approved by the company’s board of directors alone, while final dividends that use free reserves require prior approval from shareholders.

Factors influencing Dividends

Many factors affect how companies decide when and how much to pay in dividends. It is important for both investors and managers to understand these factors to see why dividends are decided the way they are and what it means for everyone involved:

• Profitability: Companies pay dividends from their profits. Higher profits usually mean larger or more frequent dividends.
• Cash Flow: Having enough cash coming in is important for paying dividends without borrowing or hurting day-to-day business.
• Financial Health: Directors look at how healthy the company is overall, including how much money it has and its debts.
• Legal Rules: Companies must follow laws and rules about how and when dividends can be paid.
• Investment Plans: Sometimes companies keep money instead of paying dividends to use it for growing or investing.
• Shareholders Expectations: What shareholders expect from dividends can influence decisions by the board of directors.
• Taxes: Taxes for the company and shareholders affect how dividends are decided.
• Industry Standards: Companies often follow what other similar companies do when deciding on dividends.
• Economic Situation: How the economy is doing, interest rates, and inflation can all affect dividend decisions.
• Company Management: Directors’ responsibilities and duties under company rules help guide how dividends are managed.

Impact of Dividend on Company’s Financial Health

Dividends form a cornerstone of a company’s financial strategy, affecting its operational choices and investor sentiments alike. Analyzing the impact of dividends sheds light on how firms handle financial resources, allure investors, and navigate intricate decisions regarding capital allocation:

• Cash Flow: Dividends reduce available cash for reinvestment, potentially limiting funding for new projects or economic downturns, necessitating careful liquidity management.
• Investor Confidence: Consistent dividends attract investors seeking stable returns, fostering trust in the company’s financial health and management’s confidence in earnings stability, thereby boosting share demand and valuation.
• Financial Flexibility: Stable dividends, while reassuring, can restrict adjustments during economic uncertainties, influencing investor perception and market confidence in capital allocation flexibility.
• Stock Price: Dividend policies strongly influence stock prices and investor confidence, with consistent payouts enhancing perceived financial strength and profitability, while cuts may signal financial challenges, impacting stock value.

Conclusion

Dividends are payments that companies make to shareholders as income. The Companies Act, 2013, lays down rules on how companies can declare and distribute dividends to their shareholders. These rules are important because they clarify the rights and duties of both companies and shareholders. Adhering to these rules helps companies avoid legal problems. Court cases related to dividends also help explain how these rules work in practice. To make sure they follow the rules correctly, companies should seek legal advice when necessary.

[1] (1883) 23 Ch D 654.

[2] [1967] Ch 254.

Fazila Khan