Businesses issue stock and pay dividends to their shareholders as a means of raising capital and encouraging investment, respectively. Issuing stock represents a sale of ownership in the company, while dividend payments compensate investors for their ownership and allow them to share in profits. When a company issues new shares of stock, the decision impacts its retained earnings and, as a consequence, many other aspects of its financial position.
Retained Earnings Defined
In financial accounting, retained earnings refers to the income that a business makes and keeps for itself rather than distributes to stockholders as a dividend. Retained earnings build up over time, even if the company spends the money it retains. All revenue becomes either retained earnings or dividends for stockholders. When a company doesn't declare a dividend, or issues a stock dividend rather than a cash dividend, its retained earnings represent its total revenue and there is no need to account for it separately.
Stock and Dividends
When a business issues new shares of stock, it increases its number of outstanding shares. This has significant consequences for some investors, but it also affects the company's dividend policy and retained earnings. Companies pay dividends on a per share basis. Therefore, if the number of outstanding shares rises, so too does the total cost of declaring a dividend. Paying out more in dividends means lower retained earnings. However, since retained earnings are cumulative, the ultimate effect is a slowing of the growth of retained earnings.
Retained Earnings vs. Cash
A reduction in the rate of growth for retained earnings does not necessarily mean that a business has less cash to work with. Paying out more in the form of dividends may still leave a business with more cash if it cuts costs and reduces its liabilities. This is because cash and retained earnings are not the same measure. Cash refers to the money a business holds in a cash account, while retained earnings go into an owners' equity account on the corporate balance sheet, before being saved as cash or spent on anything other than dividends.
If issuing stock places a company's retained earnings at risk of falling too low, business leaders have several options. The board of directors can elect to cut or eliminate the dividend. This means that even if there are more shares outstanding, the total cost of declaring a dividend can be lower than it was in the past, since the dividend payment per share is lower. A company can also take steps to reduce costs. For example, selling assets to pay off debt means that a business can keep more of its retained earnings as cash, or devote more of its revenue to dividends without depleting its new retained earnings.
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