Dividends are distributions of company earnings to the shareholders. They can be in the form of cash, stock, or property. Most unrelated investors (not directly involved with the day-to-day operations of the business) probably prefer to receive cash dividends. After all, who doesn’t like cash? However, stock dividends can be quite profitable in the long run when investors finally get around to selling the shares they receive as stock dividends.
Dividends are not an expense of doing business. They’re a balance sheet transaction only, serving to reduce both cash (in the case of cash dividends) and retained earnings.
Cash dividends
Shareholders of record receive payment in the form of cash or electronic transfer based on how many shares of stock they own. However, to pay cash dividends, a company must meet two conditions: It can’t pay cash dividends unless there are positive retained earnings, and it must have enough ready cash to pay the dividends.
For example, imagine that you own 2,000 shares of common stock in ABC Corporation. ABC has both a surplus of cash and positive retained earnings, so the board of directors decides to pay a cash dividend of $10 per share. Your dividend is $20,000 (2,000 shares x $10).
Property dividends
In this case, the corporation issues a dividend for one of the assets of the corporation. It could be any asset: inventory, equipment, vehicle, whatever.
When a company issues a property dividend, it has to restate the value of the distributed asset at fair value.
Stock dividends
Corporations normally issue stock dividends when they’re low in operating cash but still want to throw the investors a bone to keep them happy. Although no money immediately changes hands, issuing stock dividends operates the same as cash dividends: Each shareholder of record gets a certain number of extra shares of stock based on how many shares that shareholder already owns.
This type of dividend is expressed as a percentage rather than a dollar amount. For example, if a company issues a stock dividend of 5 percent, and the investor owns 1,500 shares, that investor receives an additional 75 shares of stock (1,500 x .05).
One other type of stock transaction that doesn’t reduce retained earnings is a stock split. A stock split increases the number of shares outstanding by issuing more shares to current stockholders proportionately by the amount they already own. Stock splits are typically done when a company feels the trading price of its stock is too high because this artificially reduces the price per share.
Time for an example of a stock split. Imagine that ABC Corporation stock is trading for $100, and the company feels this high price affects the average investor’s desire to purchase the stock. To get the price of the stock down to $25 per share, the company issues a four-for-one split. Every outstanding share now is equal to four shares.