A Dividend is what a company pays its shareholders, usually as a distribution of profit, based on the number of shares...
A Dividend is what a company pays its shareholders, usually as a distribution of profit, based on the number of shares owned by them. It’s not an expense for the company, but an appropriation from the profit.
Dividends are declared by the board of directors, whose actions may require the approval of shareholders. Contrary to the payment of interest and principal on a bond by an issuer, dividend payments are discretionary, rather than a legal, obligation.
Dividends can be paid in different ways.
Some companies choose to distribute cash to shareholders on a regular schedule. In the US and Canada, most companies choose a quarterly schedule of payments, whereas, in Europe and Japan, the preferred way is twice a year. In Asia, companies often favour paying dividends once a year.
Regular dividends are seen as a signal to investors that their company is growing and will share profits with shareholders.
Also known as extra or irregular dividend, this is paid by a company that does not pay dividends on a regular schedule, or a dividend that supplements regular cash dividends with an extra payment. Companies in cyclical industries, in particular, may choose to use special dividends as a means of distributing higher earnings only during years of strong earnings. During downturns, when earnings are low or negative, cash that might otherwise be used for dividends is conserved.
These are a non-cash form of dividends. With a stock dividend (popularly known as a bonus issue of shares), the company distributes additional equity to shareholders instead of cash. Although the shareholder’s total cost basis remains the same, the cost per share held is reduced. For example, if a shareholder owns 100 shares with a purchase price of R10, the total cost basis would be R1,000. After a 5% stock dividend (or 20:1 bonus), the shareholder would own 105 shares at a total cost of R1,000. However, the cost would decline to R9.52 (R1,000/105).
Superficially, the stock dividend might seem an improvement on the cash dividend. Each shareholder ends up with more shares, which did not have to be paid for, and the company did not have to spend actual money issuing a dividend. The stock dividend doesn’t affect the shareholder’s proportionate ownership in the company, nor does it change the value of each shareholder’s ownership position. From the company’s point of view, more shares outstanding broaden the shareholder base.
Cash vs stock
From a company’s perspective, the key difference between stock dividend and cash dividend is that the latter affects its capital structure. Stock dividend, on the other hand, has no economic impact on a company. Cash dividends reduce assets (because cash is being paid out) and shareholders’ equity (by reducing retained earnings). All else equal, liquidity ratios, such as cash ratio and current ratio, should decrease (reflecting the reduction in cash).
Financial leverage ratios, such as debt-to-equity ratio (total debt divided by total shareholders’ equity) and debt-to-assets ratio (total debt divided by total assets), should also increase. Stock dividends, on the other hand, do not affect assets or shareholder equity. Although retained earnings are reduced by the value of the stock dividends paid (i.e., by the number of shares issued × price per share), contributed capital increases by the same amount (i.e., the value of the shares issued).
As a result, total shareholders’ equity does not change.
The writer is associate professor of finance and accounting, IIM Shillong