Cash dividends paid by a company have a direct effect on the stockholders' equity in that company. In most cases, though, the dividend doesn't cause stockholders' equity to shrink. Rather, the dividend simply limits how much the equity will increase.
Stockholders' equity, sometimes called a company's net worth or book value, is the residual value of a company after subtracting the total value of its liabilities from the total value of its assets. A public company is owned by its shareholders -- and shareholders' equity is the value of what they own. Shareholders' equity has two main components: contributed capital and retained earnings. Contributed capital is money the company gets from selling its shares to the public. Retained earnings are profits that the company has kept in the business.
A company that turns a profit in any given year can do two things with that profit. It can hold onto it -- by reinvesting it in the company, for example, or using it to build up the company's cash reserves -- or it can distribute profit to the shareholders as a return on their investment. Of course, companies don't have to do all one thing or the other. It's common to hold onto some of the profit and distribute the rest.
The portion of the profit that gets distributed to the shareholders is a dividend. The portion that stays in the company becomes part of retained earnings -- one of the two main components of stockholders' equity. Therefore, any money distributed as a cash dividend reduces the amount going into stockholders' equity. But as long as the total cost of the dividend isn't larger than the profit, equity won't actually decrease. It just won't grow as much as it would have in the absence of a dividend.
Though it's not as common, a company may still pay a dividend even if it loses money. Doing so can be a way to encourage shareholders to hang in during lean times by giving them a tangible return on their investment or to demonstrate confidence that the company will return to profitability. If a company pays a dividend after a net loss, then the value of the dividend comes out straight out of retained earnings. In that case, stockholders' equity does see a real decline.
Investors should recognize that while a dividend reduces the value of their ownership stake in the company (by reducing the amount going into retained earnings), they aren't actually "losing" money. That equity is simply being converted to cash that goes into the shareholders' pockets. Say a company pays a cash dividend of 25 cents per share. That dividend reduces equity by 25 cents per share, but stockholders now have a quarter in cash for every share they own.
- "Financial Accounting for MBAs," Fourth Edition; Peter D. Easton, et al; 2010
- Accounting Coach; How Do Cash Dividends Affect the Financial Statements; Harold Averkamp
- Investopedia: Stockholders' Equity