At Quantum Advisory, one of the most frequently asked questions we encounter is around dividend policy. Specifically, how and why should a business implement one? There are several compelling reasons why every business owner should consider establishing a clear dividend policy, and we’re here to guide you through both the reasons and the strategies to do so effectively.
Why Implement a Dividend Policy?
1. Financial Reward
As a business owner, your business is where you’re investing your time and money, and naturally, you want to see a return on that investment. A well-implemented dividend policy focuses your efforts on activities that increase profits, which in turn increases the dividends you receive. This focus sharpens your attention on what truly drives financial health and puts more cash in the bank. Moreover, a clear dividend policy ensures that company owners are making informed decisions about how to distribute company profit, balancing personal income tax considerations and the financial health of the business.
2. Best Practice for Business
Having a dividend policy is simply good business practice. It provides a structured, methodical way of regularly getting money out of the business. This is what every large corporation does, and if you aim to operate your limited company like a mature, financially healthy enterprise, implementing a dividend policy is a must. For sole directors or company directors managing a complex business structure, a regular salary combined with Dividend payments can be an effective strategy for managing both cash flow and tax obligations, including Corporation Tax and National Insurance contributions.
3. Enhancing Business Value
One often overlooked reason to implement a dividend policy is the impact it can have on your business’s value. From an investor’s perspective, a business that consistently generates and pays out solid financial returns through dividends is far more attractive. If you can demonstrate a strong history of distributing profits, you’ll be in a solid position to argue for a higher valuation when it’s time to sell or attract investors. Additionally, understanding the tax implications, such as how to handle unfranked dividends or leveraging franking credits, can further enhance the financial health and attractiveness of your business to potential buyers.
5 Strategies for Implementing a Dividend Policy
Now that we’ve established why a dividend policy is essential, let’s explore five strategies to help you implement one effectively.
1. Fixed Payout Ratio
The simplest option for company owners is the fixed payout ratio. This method involves taking a fixed percentage of the company profit and distributing it to shareholders based on their shareholding. Whether you choose to do this monthly, quarterly, or annually, the concept is straightforward. For example, you might decide to distribute 20% of the taxable income as dividend payments. This method ensures that business owners receive a consistent income, aligning with the business budgets and financial health of the company.
2. Rolling Ratio
If your business income is more volatile, perhaps experiencing fluctuations in profit and loss, the rolling ratio might be a more suitable strategy. This method involves aggregating profits over several periods and paying out dividends based on the total profit pool. This approach helps to smooth out the ups and downs, ensuring that company money is distributed fairly, even in more unpredictable times.
3. Cash Sweep Method
For businesses that are cash positive, the cash sweep method is an effective strategy. Here, you set a minimum cash reserve necessary to maintain the company’s operations and growth. Any excess cash over this threshold is paid out as dividends. For instance, if your business needs $500,000 to operate smoothly and ends a quarter with $550,000, the excess $50,000 is distributed to shareholders. This method keeps the business in a healthy financial state while rewarding shareholders.
4. Business Value Method
If you’re building a business with the intent to sell, the business value method could be the right approach. This strategy ties dividend payments directly to the increase in business value. A commercial valuation is performed, and dividends are paid based on the uplift in value over time. For example, if your business is valued at $10 million and increases to $12 million in a year, a portion of that $2 million increase could be paid as dividends, rewarding shareholders for their role in enhancing the company’s worth.
5. Custom Formula
The custom formula is the best option if you want to get started with a dividend policy today. At Quantum Advisory, we take the operating profit for a given period and then consider several key factors. We look at any movement in working capital, strategic reinvestments into the business, cash requirements around tax obligations like Corporation Tax, and any debt repayment needs. We also account for liabilities such as franking credits, ensuring that the distribution of profits does not put the financial health of your business at risk. The result is a number that you can confidently pay out to shareholders, knowing that they are being rewarded for their efforts without compromising the company’s ability to achieve its strategic objectives. Over time, the percentage of operating profit paid out becomes consistent, allowing you to transition to a fixed payout ratio if desired.
By focusing on these core reasons and strategies, you can see that a well-thought-out dividend policy does more than just distribute profits—it enhances the financial health and overall value of your business. Whether you’re a sole director or part of a larger team of company directors, the right dividend policy can significantly impact your company’s financial health and your personal financial situation.
If you need help implementing a dividend policy or understanding the tax implications, reach out for professional tax advice.
Lastly, considering personal situations like personal expenses and salary income when planning your dividend strategy can help you make informed decisions that align with your long-term financial goals. Whether you’re navigating income taxes, dealing with personal withdrawals, or balancing regular income with dividend allowance, a comprehensive approach will ensure that you stay on top of your tax obligations and maintain the overall financial health of your business.
