Investment word of the day: Dividends—why they matter and how payout ratio is calculated; all you need to know

Investment word of the day: One of the biggest incentives for investors is to receive a share of the company's profits. Dividends are one way in which investors can receive a share of a company's profits.

What is a dividend?

A dividend is a payment made by a publicly listed company to its shareholders from its profits. It is provided in the form of cash, cash equivalents, shares, etc.

Indian market regulator Sebi defines dividend as “the profit of a company, which is not retained in the business and is distributed among the shareholders in proportion to the amount paid up on the shares held by them.”

Dividends are typically paid from the share of profits after paying all the other expenses of the company. The distribution of dividends is declared by the board of directors. However, it must be noted that a company is not obliged to provide dividends every time. Sometimes, companies may choose to use the profits for other purposes of the business. In certain cases, profits are reinvested in the business.

Step-by-step process of dividend distribution

Step 1: Companies report profits and losses incurred during a specific period of time.

Step 2: The management of the company plans on whether to distribute the profits to the shareholders or reinvest it in the business.

Step 3: After receiving the majority of shareholder's approval, the board of directors declare a dividend.

Step 4: The company declares dates for dividend distribution and checks the eligibility of shareholders.

Step 5: The shareholders receive the dividends.

Types of dividend

According to the time of the distribution, there are three types of dividends.

Interim dividend

A company declares an interim dividend before preparing the annual accounts at the end of a financial year, which begins on April 1 and ends on March 31 of the following year.

Final dividend

This type of dividend is calculated at the end of a year after preparing the annual financial statement on the basis of the final profits earned by the company. The board of directors declare the final dividend at the Annual General Meeting of the company.

Special Dividend

A company declares a special dividend at a time when it has accumulated enough profits which could be distributed to the investors. In most cases, the amount of a special dividend is higher than other types of dividends.

How is dividend calculated?

The dividend amount is determined by the dividend payout ratio, which indicates the net profits that could be distributed among the shareholders.

The dividend payout ratio can be calculated by dividing dividends paid by a company in a period by its net profit earned.

When do shareholders get dividends?

Dividends are not paid at a specific time. They can be paid monthly, quarterly, semi-annually, or annually. In some cases, if the company reports high profits, it may also distribute special dividends. Investors must check stock exchange websites to determine whether a company is paying dividends.

In short, dividends are a reward for shareholders earned due to the good performance of the company. However, it must be noted that dividends do not change the total market value of the company and it is not a legal right of the shareholders.