Dividends are payments to stockholders of a corporation. The payments can be either in the form of a direct cash deposit to the stockholder's account, or distribution of more shares. The two types of payment are referred to as cash and stock dividends, respectively. These two types of dividends impact the company and the shareholders differently.
They entail different risks and have different effects on the balance sheet. Especially during tough financial times, issuing the wrong type of dividend may have grave consequences for the corporation. When a company declares a cash dividend, it will create a legal payment obligation for itself. The accountant will create a new line item called Cash Dividend Payable. The Retained Earnings account will decline by the same amount.
The new account is a liability account, and, from an accounting standpoint, it is treated in exactly the same fashion as a payment obligation to a bank. Later on, when the cash is sent to stockholders, the accountant will decrease the Cash Dividend Payable account as well as the Cash account in the balance sheet, each by the same amounts. As a result, the company's cash holdings and Retained Earnings will have gone down by the same amount. Stock dividends have no influence on the asset side of the balance sheet.
Since the corporation does not distribute anything that makes up its asset base, its total asset size and composition will remain the same. Because the company will issue and distribute new shares, the number of outstanding shares will increase. On the other side of the balance sheet, the accountant will reduce the Retained Earnings account and increase the Paid in Capital account. In practical terms, this means that the accumulated profits, whose destiny was previously uncertain, are now absorbed into the capital structure of the firm.
While receiving additional shares instead of cash may sound like an unappealing proposition from a cash-seeking stockholder's perspective, this is not necessarily the case, because the stockholder can sell some or all of the new shares and obtain cash. The risk is that the cash that is now retained within the company may be wasted by the management. For a stockholder, cash in the hand is safe; cash put back into the business always represents a risk, no matter how well-run the company.
Should the gamble pay off and the reinvested cash open the door to higher company profits, the future cash dividend disbursements can more than make up for the lack of earlier cash payments. From the company's perspective, a stock dividend is safer, as it allows management to more easily honor other payment obligations. As a general rule, corporations should pay cash dividends only if they are absolutely certain that they will have no problems paying other stakeholders, such as employees, lenders and suppliers.
If management miscalculates the situation and distributes the cash in the form of a dividend, it may be unable to pay other legal claimants. This can result in legal action, and even in bankruptcy of the company. Therefore, only stable and consistently profitable companies with low levels of debt tend to pay dividends.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. Cash Dividend When a company declares a cash dividend, it will create a legal payment obligation for itself. Stock Dividends Stock dividends have no influence on the asset side of the balance sheet. Stockholder's Perspective While receiving additional shares instead of cash may sound like an unappealing proposition from a cash-seeking stockholder's perspective, this is not necessarily the case, because the stockholder can sell some or all of the new shares and obtain cash.
Company's Perspective From the company's perspective, a stock dividend is safer, as it allows management to more easily honor other payment obligations.More...