Retained Earnings vs. Preferred Dividends

A company that retains some of its profits is able to fund growth.

A company can decide to keep its income as retained earnings at the end of the financial year or pay it out to shareholders as dividends. Some companies do both. There may be situations when the income statement of a company cannot allow it to pay all dividends. When this happens, the company pays the preferred dividends first.

Retained Earnings

Retained earning is the proportion of a company's annual profit that is set aside to finance certain operations such as expansion. This is one of the sources of financing for a company as it constitutes less expensive funds compared to other sources such as bank loans. Setting aside a proportion of a company's profit cushions it against the shock of emergencies. If the company takes a big loss, for instance, the retained earnings can be used to stabilize the company's operations.

Funds Readily Available

Retained earnings are readily available for deployment for various uses since they remain under the control of the company. Companies use their retained earnings to help grow the business and to fund major operations. The fact that management can access this money quickly whenever the need arises means the company can avoid the time-consuming bureaucracy of sourcing for other funds such as loans or venture capital.

Preferred Stock

Preferred dividends are the dividends that are paid to holders of preferred stock, usually at a fixed dividend rate. Most of these preferred stocks are cumulative, which means a dividend payment must be made at some point even if it is skipped during a bad year. If there is not enough money to pay all dividends, preferred stockholders are first paid in full and the remaining amount is shared by ordinary shareholders. The same applies whenever the company is liquidating. Preferred stocks, therefore, carry less risk.

Reliability

Preferred stock is treated as an equity security. Dividends paid on preferred stock are taken after tax, just as they are for common stock. Preferred stock is a reliable source of income to investors since the amount of dividends paid on it is fixed. Holders of preferred stock don’t have any voting rights, but they can convert to shares of common stock.

References

• College of Commerce and Business Administration: Dividend Transactions
• Money-zine: Buying Preferred Stock