Updated July 19, 2023
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 paid on the preferred stocks is known as preferred dividends. Being a preferred stockholder is beneficial since preferred dividends are paid regularly by the company each year at a fixed rate, unlike common stocks, where dividend payments are subject to management discretion. Further, it is paid in priority to common stock dividends, and shareholders of preferred stocks enjoy a preferential right to dividend payments. Only the profits that remain after the allocation of preferred dividends can be allocated for the dividend payments of common stocks.
The Formula for Preferred Dividends
It is 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.
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:
The preferred dividend is calculated using the formula given below.
- Preferred Dividend = $100 * 6% * 10,000
- Preferred Dividend = $60,000
Preferred Dividends in Balance Sheet
The Board declares they will 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 amount of the dividend debits the retained earnings account, 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 increase year to year if the dividend gets approved each year but remains unpaid. The payable dividend will be shown as a current liability for cumulative preferred stocks. However, in the case of non-cumulative preferred stocks, the dividend, if not paid for a year, lapses. 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 pay dividends equally until the time the shares are bought back or the company liquidates. If 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’s 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 their 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 their 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 members approve the same will the company pay it. |
| Priority of Payment | Preferred dividends are paid before distributing profits to the equity stockholders. | Common dividends are to be paid only when sufficient profits are available after the distribution of preferred dividends. |
Advantages
- 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 accumulation.
Disadvantages
- 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.
Conclusion
It offers 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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