What are Cash Dividends?
Cash dividends represent ownership to a firm’s distributed profits to shareholders and provide an incentive to investors to own the shares of large companies, even if they are not growth-oriented. Cash dividends are paid directly in money, as opposed to being paid as a stock dividend or other form of value. Most brokers offer a choice to reinvest or accept cash dividends.
From the Latin “dividendum” meaning a “thing to be divided,” a dividend is a distribution of profits made by a corporation to its shareholders.
A cash dividend is declared by a corporation’s Board of Directors, and is paid to shareholders on a per share basis out of a company’s net profits. Companies usually pay dividends on a fixed schedule, such as quarterly, semi-annually, or yearly.
In the U.S., quarterly dividends are common, while in Australia and Japan, semi-annual dividends are typical, and in Germany, annual dividends are the norm. At any time, a company can declare a special dividend to reflect a special situation, such as the sale of a major asset.
Cash dividends are distributed to shareholders as electronic funds transfers or as paper checks. Shareholders holding preferred shares often receive preference over, and a slightly higher rate, than those holding common shares.
What Does Cash Dividends Mean?
Companies that pay cash dividends typically generate strong cash flows for subsequent quarters and are widely viewed as financially healthy. However, most of the dividend-paying companies are not growth-oriented. Instead, they are seeking to increase shareholder value and generate a steady stream of income for their shareholders.
They are also seeking expansion into new markets and are focusing on new investment opportunities. Some dividend-paying companies set their dividend payout ratio ideally around 50%-55%, and they distribute the relevant amount of retained to their shareholders as a dividend.
While many firms pay regular dividends, there are special cash dividends that are distributed to shareholders after certain nonrecurring events such as legal settlements or the borrowing of money for large, one-time cash distributions. Each company establishes its dividend policy and periodically assesses if a dividend cut or an increase is warranted. Cash dividends are paid on a per-share basis.
Understanding Cash Dividends
Cash dividends paid by public companies follow a process defined by the regulatory organizations, which revolves around specified dates. The following dates define the dividend process.
- Declaration Date is the date on which a company’s Board of Directors publicly announces its approval of a dividend payment; a liability then appears on the company’s books.
- Holder of Record Date (or simply the Record Date) is the date on which shareholders of record are eligible to receive the dividend. In other words, if you are a shareholder on the record date, you will receive the specified dividend.
- In-Dividend Date is the last day on which shares bought will receive the dividend. (Since stock transactions require two days for settlement, the in-dividend date is two days prior to the record date for that dividend.)
- Ex-Dividend Date is the date on which new purchasers will no longer receive the dividend. The ex-date occurs one day prior to the Record Date, This is also the date that the exchanges adjust the price of the stock lower by the amount of the dividend.
- Cum Dividend Period is the number of days between the Declaration Date and the Ex-Dividend Date.
- Payment Date is the date on which the dividend is actually paid to shareholders. It is the date you would actually receive the money on your brokerage account if you were eligible to receive it. (Payment dates might be as much as a few weeks after the record date to allow time for companies to process the payments.)
Which Companies Pay Dividends?
Companies that pay dividends typically enjoy stable cash flows, and their businesses are commonly beyond the growth stage. This business growth cycle partially explains why growth firms do not pay dividends—they need these funds to expand their operations, build factories, and increase their personnel.
Certain dividend-paying companies may go as far as establishing dividend payout targets, which are based on generated profits in a given year. For example, banks typically pay out a certain percentage of their profits in the form of cash dividends. If profits decline, dividend policy can be postponed to better times.
Cash Dividend Calculation Example
Companies declare cash dividends as payments per share of stock owned, making the dividend calculation for any shareholder a simple calculation. The formula would be:
Total cash dividend = (dividend per share) x (# of shares held)
For example, if a company pays a quarterly dividend of $0.50 per share and a shareholder owns 1000 shares, the total cash amount of the dividend would be:
(1000) x ($.50) = $500
An important way to measure a dividend for investors is the dividend yield, which is the percentage return of a company’s current dividend displayed on an annualized basis. This measure allows shareholders to easily compare their dividend to that of other stocks or to selected fixed income instruments. The formula for the dividend yield is as follows:
Dividend yield = (Current dividend)/(current stock price) x (# of(dividends paid in one year) x 100
If the sample dividend above was paid on a stock selling at $80 per share, then the dividend yield would be:
Dividend yield = ($.50)/($80) x 4 = 2.5%
Tip: When considering stocks based on their dividend yield, it’s a good idea to examine company financials to determine a company’s ability to sustain or grow dividends at the current rate and whether there are prospects for share price appreciation as well.
How to Account for Cash Dividends
When a cash dividend is declared by the board of directors, debit the Retained Earnings account and credit the Dividends Payable account, thereby reducing equity and increasing liabilities. Thus, there is an immediate decline in the equity section of the balance sheet as soon as the board of directors declares a dividend, even though no cash has yet been paid out.
When a dividend is later paid to shareholders, debit the Dividends Payable account and credit the Cash account, thereby reducing both cash and the offsetting liability. The net effect of these two transactions is to reduce cash and equity, which means that the entire impact of the cash dividend is contained within the balance sheet; there is no impact on the income statement, though the payment will appear as a use of cash in the financing activities section of the statement of cash flows.
Importance of Cash Dividend
Multiple factors impact the size and timings of dividends:
- Firms may distribute cash dividends to maintain specific financial ratios
or manage any cyclical tendencies of the firm. Let’s assume a firm is selling Air-Conditioner’s which have high demand during the summer season. They may declare a dividend during the winter season, which will help to maintain share prices. It is during the winter season the demand for such product dries up, and stock prices can tank.
- Firms in their maturity stage tend to pay regular dividends as compared to the fast-growing firms as they are focussed on re-investing the cash for the growth of the business.
- Companies do not always pay dividends in cash and may pay stock dividends. The shareholders may also be given a choice between cash and stock or permit the shareholders to buy additional shares with this dividend (dividend reinvestment plan).
- Dividend yields display the overall sentiment of the market. Market experts observe the trend of cash dividend provided, and thus observations are made accordingly over a while, including periods of distress.
- The taxation laws of the respective country are to be considered before the declaration. Laws keep changing regularly, and thus, companies are required to adhere to them. Generally, firms have to pay DDT (Dividend distribution tax) before distributing the same to the stockholders.