What Are Dividends?
Adividendis a method of redistributing a company's profits to shareholders as a reward for their investment. Companies are not required to issue dividends on common sharesof stock, though many pride themselves on paying consistent or constantly increasing dividends each year. When a company issues a dividend to its shareholders, the dividend can be paid either in cash or by issuing additional shares of stock. The two types of dividends affect a company'sbalance sheet in different ways.
Key Takeaways:
- Companies issue dividends to reward shareholders for their investment.
- Dividends paid can be in the form of cash or additional shares called stock dividends.
- Cash dividends affect the cash and shareholder equity on the balance sheet; retained earnings and cash arereducedby the total value of the dividend.
- Stock dividends have no impact on the cash position of a company and only impact the shareholders equity section of the balance sheet.
Understanding Dividends
When most people think of dividends, they think ofcash dividends. However, companies can also issue stock dividends. When a company issues a stock dividend, it distributes additional quantities of stock to existing shareholders according to the number of shares they already own. Dividendsimpact the shareholders' equity section of the corporate balance sheet—the retained earnings, in particular.
Retained Earnings on the Balance Sheet
Retained earnings are theamount of money a company hasleft over after all of its obligations have been paid. Retained earnings are typically used for reinvesting inthe company,paying dividends, or paying down debt.While net profitis the amount of income that remains after accounting for the cost of doing business in a given period, retained earnings are the amount of income accrued over the years that has not been reinvested in the business or distributed to shareholders.
Cash Dividends on the Balance Sheet
Cash dividends affect two areas on the balance sheet:the cash andshareholders' equityaccounts.Investorswill not find aseparate balance sheet account for dividends that have been paid. However, after the dividend declaration andbefore the actual payment,the company records a liabilityto its shareholders in the dividend payable account.
After the dividends are paid, the dividend payable is reversed and is no longer present on the liability side of the balance sheet.When the dividends are paid, theeffecton the balance sheet is adecrease inthecompany'sretained earningsand its cash balance. In other words, retained earnings and cash arereducedby the total value of the dividend.
By the time a company's financial statements have been released,the dividend is already paid, and the decrease in retained earnings and cash are already recorded. In other words, investors will not see the liability account entries in the dividend payable account.
For example, assume a company has $1 million in retained earnings and issues a 50-cent dividend on all 500,000outstanding shares. The total value of the dividend is $0.50 x 500,000, or $250,000, to be paid to shareholders. As a result, both cashand retained earnings arereduced by $250,000 leaving $750,000 remaining in retained earnings.
The ultimate effect of cash dividends on the company's balance sheet is a reduction in cash for $250,000 on the asset side, and a reduction in retained earnings for $250,000 on the equity side.
Stock Dividends on the Balance Sheet
Whilecash dividendshave a straightforward effect on the balance sheet, the issuance of stock dividends is slightly more complicated. A company's executive management mightwantto issue stock dividends to its shareholders if the companylacks excess cash on hand or if they want todecreasethe value of existing shares, driving down the price-to-earnings ratio (P/E ratio) and otherfinancial metrics. Stock dividends aresometimes referred to as bonusshares or a bonus issue.
Stock dividends have no impact on the cash position of a company and only impact the shareholders' equity section of the balance sheet.If the number of shares outstanding is increased by less than 20% to 25%, the stock dividend is considered to be small. Alarge dividend is when the stock dividend impacts the shareprice significantly and is typically anincrease inshares outstanding by more than 20% to 25%. Alarge dividend can oftenbe considered a stock split.
When a stock dividend is declared, the total amount to be debited fromretained earnings is calculated by multiplying the currentmarket priceper share bythe dividend percentage and by the number of shares outstanding. If a company pays stock dividends, thedividends reduce the company's retained earnings and increase the common stock account.Stock dividends do not result in asset changes to the balance sheet but rather affect only the equity side by reallocating part of the retained earnings to the common stock account.
For example, say a company has 100,000 shares outstanding and wantstoissue a 10% dividend in the form of stock. If each share is currently worth$20 on the market, the total value of the dividend would equal $200,000. The two entries would include a$200,000 debittoretained earnings and a $200,000 credit to the common stock account. The balance sheet would be balancedfollowing the entries.
