Companies pay dividends to shareholders in return for using their capital. Dividends are paid out of the company’s earnings after tax (EAT).
Dividends also help determine the value of a company’s shares. They signal to shareholders that the business is earning enough to support growth and share a portion of the gains with its owners. This promotes shareholder confidence in the management team.
In an incorporated company, dividends must be approved and declared by the board of directors. Shareholders are paid according to how many shares they own.
Any earnings after tax that are not paid out as dividends are added to the retained earnings account on the balance sheet and can be used for ongoing operations or investment.
More about dividends
The income statement below shows how ABC Co. calculated its dividends for the period ending March 31, 2012. Out of $20,000 in earnings after tax (EAT), the company pays $10,000 to shareholders as dividends (at a dividend payout ratio of 50%). It keeps the remaining $10,000 as retained earnings.