Owner's drawings and dividends

What are dividends?

Dividends are the same as owner's drawings if you have learnt accounting. For the benefit of those who have not, owner's drawings are when the owner of the business decides to withdraw some money or capital as the busy-ness people like to call it, for personal use such as funding a house, paying tuition fees, making an investment, etc.

Dividends are a good sign of a company's financial health. Financial health meaning the money which the company owns to fund its operations. When a company pays a dividend, that tells two things:-

1. The company has alot of cash
2. The company doesn't know what to do with the cash, so its returning them to the owners

When a company makes a profit, it then has a decision to make, either to use the dividends for expansion plans, reinvestment into operations, or to "give out" the profits to its shareholders. The choice depends on the particular stage a company is in, but more on that in later entries. If a company has matured, it had rather give out its profits in the form of dividends. On the other hand, if a company is growing rapidly and requires alot of capital to further progress, it had rather keep its profits for reinvestment.

Lets go into the world of tax for a moment. When an individual receives $6000 or more a year(this could vary depending on your country's tax rules) the individual will get taxed on any income he or she receives. Dividends are a form of income. Sometimes a company decides to prepay the tax on the dividend when received by the individual. This is known as franking. 100% franked dividends means dividends received that are not subject to tax anymore.

Dividend yield is the form of measurement that most companies use to compare amount of dividends released by different companies. Dividend yield is calculated as:-

Dividend yield = (Dividend per share)/Share price

The benefit is we can measure the amount of dividends the company pays us for each dollar invested in the company. A high dividend yield is 5%. That means, for every dollar we invest in a company, the company will give 5 cents worth of dividends each year(assuming they maintain this rate). Hence, if the share price were to stay the same and not budge, it would take us 20 years to get the full return on the initial amount invested.

The limitations to this is of course the fact that dividend yield is based on the share price. Our assumption that the share price never budges is never true in real life. Share prices move constantly, like a roller coaster ride that's never ending. So the dividend yield will be affected by the movements in share prices.

Depending on our circumstances, especially age and tolerance for risk, we might choose different companies that give out different dividend yields. For a youngster that is ready to take on the world, he might choose a company with low dividend yield, ensuring that most of the companies profits will be reinvested and he is hoping for further growth in the company, and hence its share price. For the elderly, they might instead prefer high dividend yield companies because of their needs and that they already have experienced enough of the financial worlds.

For hands-on experience, companies usually pay dividends by cheque or direct debit into your bank account, or any other bank account who you wish to nominate. In the real world, the moment any company announces that it has decreased its dividend, what follows suit is a huge selling out because people are afraid the company is in trouble. Sometimes, its not always the case. And the drop in share price might just be your opportunity to come in at a bargain price.