Most investors like cash dividends. After all, it's kind of like having your cake and eating it too. Not only do you own the shares, you get paid too. As you delve further into investing, however, it can be valuable to understand where that dividend comes from, and how it affects the company's bottom line and long-term health.
When you buy stock, you are buying ownership in the underlying company. As an owner, you have a right to any profit the company makes in proportion to the number of shares you own. A dividend is the payout, in cash, of some of those profits.
Net income is equivalent to profit -- it's the sales revenue for a given period less all expenses incurred to generate that revenue. In everyday terms, it's the money you have left in the bank account once you've paid all your bills for the month. A company can save that money as retained earnings for future use in the business, or it can pay it out to shareholders as a dividend. In this sense, a cash dividend doesn't change the net income -- the company still made that money. Rather, it describes what the company did with the extra cash. Cash dividends do affect retained earnings, or the amount of cash management has on hand to reinvest in business activity.
Most companies have a dividend policy, or set of guidelines that determine when a dividend will be paid. This policy varies from company to company, and even from year to year as the business moves through various stages of growth. New and expanding companies may pay out very little in dividends, preferring to use the money to fund growth. The same is true of companies dealing with tough economic times. Companies that are well established and growing more slowly don't need as much cash on hand. As a result, they tend to pay out dividends regularly and at a higher rate than companies that are still growing.
A company's dividend policy should be in line with it's stated goals. As an investor, you want to see a dividend policy that is consistent, but one that changes with the business environment. The board of directors generally shouldn't raise a dividend payment if profits are dropping, for example. In the same way, if a healthy company is retaining most of its earnings, it should be using that cash. You don't want to see loans or bonds financing projects that could be funded with retained earnings. Each situation is different, so review the dividend information in context with the rest of the financial reports to get a complete picture.
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Nola Moore is a writer and editor based in Los Angeles, Calif. She has more than 20 years of experience working in and writing about finance and small business. She has a Bachelor of Science in retail merchandising. Her clients include The Motley Fool, Proctor and Gamble and NYSE Euronext.