Definition of Preferred Dividends
Preferred dividends refer to the dividend distribution made by the company to its shareholders holding preferred stocks out of the profits of the company before making any distribution to the stockholders of the common stock. It means that preferred dividends are paid in priority to the dividend paid on the common stocks of the company.
Explanation
Preference shares or preferred stocks are issued by a company carrying a fixed rate of dividends. The dividend that is paid on the preferred stocks is known as preferred dividends. Being a preferred stockholder is beneficial since preferred dividends are to be paid regularly by the company each year at a fixed rate, unlike common stocks where dividend payments are subject to management discretion. Further, preferred dividends are paid in priority to common stock dividends, and shareholders of preferred stocks enjoy a preferential right to dividend payments. Only the profits that are remaining after the allocation of preferred dividends can be allocated for the dividend payments of common stocks.
Formula for Preferred Dividends
Preferred dividends are paid as a fixed percentage of the par value of the preferred stock. The calculation can be done using the following formula:
Thus, it can be easily calculated by multiplying the par value of the total number of preferred stocks by the fixed rate of dividends. The rate of dividend at which the stocks are issued is fixed at the time of the issue of such stocks itself.
Example of Preferred Dividends
Suppose a company-issued 10,000 units of 6% preferred stocks at the par value of $100 each. The total amount of preferred dividend that the company shall pay for a year can be calculated as follows:
Preferred Dividend is calculated using the formula given below
Preferred Dividend = Par Value * Dividend Rate * Number of Preferred Stocks
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- Preferred Dividend = $100 * 6% * 10,000
- Preferred Dividend = $60,000
Preferred Dividends in Balance Sheet
They are declared by the Board are to be approved at the members’ annual meeting. Since approval takes place in the next accounting year after the balance sheet date, the amount payable for approved dividends is not shown as a liability in the balance sheet of the year to which the dividend relates. The liability is booked in the accounting year in which it is approved. The retained earnings account is debited by the amount of dividend and dividend payable liability is credited. The liability gets settled when the same is paid to the shareholders. Thus, if the liability is paid in the same year there will be no balance at the end. In the case of cumulative preferred stocks, where the dividend gets accumulated if the same is unpaid, the liability will get increased year to year if the dividend gets approved each year but remains unpaid. Dividend payable will be shown as a current liability in case of cumulative preferred stocks. However, in the case of non-cumulative preferred stocks the dividend if not paid for a year lapse. In such a case, no liability will be created for dividends until and unless the same is paid since the company is under no obligation to pay the dividends compulsorily.
Importance
Preferred dividends are paid on the preferred stocks at a fixed rate. The company has to be pay dividends equally until the time the shares are bought back or the company liquidates. In case there are insufficient profits or for any other reason, a company may choose not to pay dividends during a particular year and accumulate the same for the next year. The dividends if remain unpaid accumulate and become dividends in arrears. The company needs to pay dividends in arrears first before it pays the current year dividend. However, this is only possible in cumulative preferred stocks since the unpaid dividend lapses in the case of non-cumulative preferred stocks.
Preferred Dividends vs Common Dividends
Below are the differences:
| Basis of Difference | Preferred Dividends | Common Dividends |
| Rate of Dividend | The rate of dividend is fixed and pre-determined for preferred stocks. | Common dividends are paid on equity stocks and there is no fixed rate for its payment. They are paid as per the availability of profits and as per management’s discretion. |
| Company’s obligation | For cumulative preferred stocks, the dividends are accumulated until paid and the company is obligated to pay them in entirety. | In the case of common dividends, the company is not under any obligation to pay dividends regularly. Only when management declares a dividend and the same is approved by members the company has to pay it. |
| Priority of Payment | Preferred dividends are paid before making any distribution to profits to the equity stockholders. | Common dividends are to be paid only when sufficient profits are available after the distribution of preferred dividends. |
Advantages
Some of the advantages are given below:
- They are paid at a high rate. The rate is higher than compared to debt instruments.
- Preferred stocks are usually issued as cumulative and the dividend on such stocks is guaranteed even if the same is paid at a certain future date after accumulations.
- The rate of dividend is fixed in case of preferred dividends and that is beneficial if market returns become lower.
- They are paid in priority to the common dividends.
Disadvantages
Some of the disadvantages are given below:
- The rate of dividends is not going to increase in accordance with inflation and if the market situations are good then a lower rate of dividends will be a loss for the investors.
- If the preferred stocks are non-cumulative then dividends are not guaranteed.
Conclusion
It offer good returns to the investors than debt instruments. That’s why some investors park their money in preferred stocks to enjoy fixed returns. The company issues preferred stocks so that the voting rights don’t get diluted and there is no additional interference from the stockholders.
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