Would you ever pay out dividends if your firm’s annual net profit is negative?

When a company pays cash dividends to its shareholders, its stockholders' equity is decreased by the total value of all dividends paid; however, the effect of dividends changes depending on the kind of dividends a company pays. Stock dividends do not have the same effect on stockholder equity as cash dividends.

Key Takeaways

• Companies issue dividends as a way to reward current shareholders and to encourage new investors to purchase stock.
• A company can pay dividends in the form of cash, additional shares of stock in the company, or a combination of both.
• To calculate stockholder equity, take the total assets listed on the company's balance sheet and subtract the company's liabilities.
• Cash dividends reduce stockholder equity, while stock dividends do not reduce stockholder equity.

What Are Dividends?

When a company is doing well and wants to reward its shareholders for their investment, it issues a dividend. A dividend is a distribution of a portion of a company's earnings to its shareholders. Dividends are paid out either by cash or additional stock, and they offer a good way for companies to communicate their financial stability and profitability to the corporate sphere in general.

Stocks that issue dividends tend to be fairly popular among investors, so many companies pride themselves on issuing consistent and increasing dividends year after year. In addition to rewarding existing shareholders, the issuing of dividends encourages new investors to purchase stock in a company that is thriving.

How Dividends Are Paid

Dividends are generally paid in cash or additional shares of stock, or a combination of both. When a dividend is paid in cash, the company pays each shareholder a specific dollar amount according to the number of shares they already own. A company that declares a $1 dividend, therefore, pays $1,000 to a shareholder who owns 1,000 shares.

Choosing dividend stocks is a great way to create an income stream investment strategy.

In a stock dividend, shareholders are issued additional shares according to their current ownership stake. If the company in the above example issues a 10% stock dividend instead, the shareholder receives an additional 100 shares. Some companies offer shareholders the option of reinvesting a cash dividend by purchasing additional shares of stock at a reduced price.

Stockholder Equity

Stockholder equity represents the capital portion of a company's balance sheet. The stockholders' equity can be calculated from the balance sheet by subtracting a company's liabilities from its total assets. Although stock splits and stock dividends affect the way shares are allocated and the company share price, stock dividends do not affect stockholder equity.

Stockholder equity also represents the value of a company that could be distributed to shareholders in the event of bankruptcy. If the business closes shop, liquidates all its assets, and pays off all its debts, stockholder equity is what remains. It can most easily be thought of as a company's total assets minus its total liabilities.

One of the chief components of stockholder equity is the amount of money a company raises through the sale of shares of stock, called equity capital; however, even private companies, which are not publicly traded, have stockholder equity.

Though uncommon, it is possible for a company to have a negative stockholder equity value if its liabilities outweigh its assets. Because stockholder equity reflects the difference between assets and liabilities, analysts and investors scrutinize companies' balance sheets to assess their financial health.

Retained Earnings

Stockholders' equity includes retained earnings, paid-in capital, treasury stock, and other accumulative income. If assets and liabilities figures are not readily available, the stockholder equity can be calculated by adding preferred stock to common stock and adding additional paid-in capital, adding or subtracting retained earnings, and subtracting treasury stock. Stockholder equity is usually referred to as a company's book value.

The retained earnings section of the balance sheet reflects the total amount of profit a company has retained over time. After the business accounts for all its costs and expenses, the amount of revenue that remains at the end of the fiscal year is its net profit.

The company can choose to do one of three things with its profit: pay dividends to shareholders, reinvest the funds into the company, or leave it on account. The portion of profits left on account is rolled over each year and listed on the balance sheet as retained earnings.

The Effect of Dividends

The effect of dividends on stockholders' equity is dictated by the type of dividend issued. When a company issues a dividend to its shareholders, the value of that dividend is deducted from its retained earnings.

Even if the dividend is issued as additional shares of stock, the value of that stock is deducted; however, a cash dividend results in a straight reduction of retained earnings, while a stock dividend results in a transfer of funds from retained earnings to paid-in capital. While a cash dividend reduces stockholders' equity, a stock dividend simply rearranges the allocation of equity funds.

Example of a Cash Dividend

Assume company ABC has a particularly lucrative year and decides to issue a $1.50 dividend to its shareholders. This means for each share owned, the company pays $1.50 in dividends. If ABC has 1 million shares of stock outstanding, it must pay out $1.5 million in dividends.

The stockholder equity section of ABC's balance sheet shows retained earnings of $4 million. When the cash dividend is declared, $1.5 million is deducted from the retained earnings section and added to the dividends payable sub-account of the liabilities section. The company's stockholder equity is reduced by the dividend amount, and its total liability is increased temporarily because the dividend has not yet been paid.

When dividends are actually paid to shareholders, the $1.5 million is deducted from the dividends payable subsection to account for the reduction in the company's liabilities. The cash sub-account of the assets section is also reduced by $1.5 million.

Since stockholders' equity is equal to assets minus liabilities, any reduction in stockholders' equity must be mirrored by a reduction in total assets, and vice versa.

Example of a Stock Dividend

The accounting changes slightly if ABC issues a stock dividend. Assume ABC declares a 5% stock dividend on its 1 million outstanding shares. If the current market price of ABC's stock is $15, then the 50,000 dividend shares have a total value of $750,000.

When the dividend is declared, $750,000 is deducted from the retained earnings sub-account and transferred to the paid-in capital sub-account. The value of the dividend is distributed between common stock and additional paid-in capital.

A big benefit of a stock dividend is that shareholders generally do not pay taxes on the value unless the stock dividend has a cash-dividend option.

The common stock sub-account includes only the par, or face value, of the stock. The additional paid-in capital sub-account includes the value of the stock above its par value. If ABC's stock has a par value of $1, then the common stock sub-account is increased by $50,000 while the remaining $700,000 is listed as additional paid-in capital.

The net effect of the stock dividend is simply an increase in the paid-in capital sub-account and a reduction of retained earnings. The total stockholder equity remains unchanged.

Are Dividends Part of Stockholder Equity?

Dividends are not specifically part of stockholder equity, but the payout of cash dividends reduces the amount of stockholder equity on a company's balance sheet. This is so because cash dividends are paid out of retained earnings, which directly reduces stockholder equity.

Are Dividends Assets or Equity?

For shareholders, dividends are considered assets because they add value to an investor's portfolio, increasing their net worth. For a company, dividends are considered a liability before they are paid out.

Is a Cash Dividend Better or a Stock Dividend?

Whether a cash dividend or a stock dividend is better depends on the shareholder and their financial profile. If an individual is dependent on an income stream, then a cash dividend would be a better option. On the other hand, if a shareholder is not in need of cash right away, a stock dividend is a better option as it allows for further investment in a company that can balloon into bigger payouts in the future.

The Bottom Line

Dividends are a portion of company earnings paid out to shareholders. Dividends can be paid out either as cash or in the form of additional stock, both of which have a different impact on stockholder equity. Cash dividends reduce stockholder equity, while stock dividends do not reduce stockholder equity.