When a corporation makes a net profit, it can do a number of things with that money. Some may be paid out to shareholders, and some may be reinvested in the company's growth. If a company chooses to keep that profit on its books rather than paying it out or spending it, an accounting entry known as retained earnings is used. Since a dividend payment reduces retained earnings, most companies will not declare a cash dividend in excess of retained earnings. It is possible for companies to declare stock dividends in excess of retained earnings, even though they may not be paid until the retained earnings balance is adequate.
Purpose of Retained Earnings
Retained earnings is the commercial equivalent of a consumer savings account. As a company earns profit, it must decide to either save the excess money, reinvest it in its operations or return it to its investors. Companies can also use a positive retained earnings balance to cover net losses. During a fiscal quarter or year, a company may experience an income shortage, which it covers with the excess earned from previous accounting periods. A net loss that occurs when the retained earnings balance is zero or negative results in larger negative balance.
Dividends are income payments made to common and preferred stockholders. Some investors choose to invest in securities that have a history of regular dividend payments. Rather than waiting for a potential return on the future sale of the stock, investors realize a secondary source of income. Dividend payments are in addition to any capital gains an investor may eventually realize on the sale of the stock. They are similar to the interest payments that a bond accumulates prior to its maturity date.
Companies issue cash dividends when its board of directors declares a payment. Some firms do this periodically or regularly, depending upon their stock's dividend policy. Other companies will rarely declare a cash dividend. All dividend amounts are paid per share and the total amount does not usually exceed the company's current retained earnings balance. For example, a company with a retained earnings balance of $40,000 might declare a cash dividend of $20,000. If the amount of outstanding stock is 25,000 shares, the dividend would equal .80 cents per share.
Firms may choose to declare dividends in the form of new stock. If the value of the stock exceeds the retained earnings balance, the stock is usually not issued until the balance is large enough to cover it. When stock dividends are declared, preferred stock takes preference over common stock. For instance, if a company with a retained earnings balance of $25,000 declares a preferred stock dividend of $30,000 and a common stock dividend of $10,000, the $5,000 in preferred stock will be issued first.