Whether you're a new or experienced investor, you may have a hard time explaining what preferred stock is. And, how does it affect a company's worth? Many people are familiar with common stock. But preferred stock is different; it has qualities of both a stock and a bond.
Preferred stocks typically pay fixed dividends. These are distributions of company profits. Preferred stock dividends play a role in understanding income statements.
Learn about the role of preferred stock on an income statement. And find out how it influences the reported profit and loss in companies that have issued a large amount of preferred stock.
How Does Preferred Stock Relate to Net Income?
An income statement is a type of financial statement. Income statements include a company's revenues, expenses, gains and losses, and net income. Net income is the total after-tax profit made for the period. This is done before deducting the required dividends paid on the outstanding preferred stock.
You can't completely rely on reported net income as it appears at this point, though. This is due to the nature of preferred stock and preferred stock dividends. Regular cash dividends paid on common stock are not deducted from the income statement.
For instance, let's say a company made $10 million in profit and paid $9 million in dividends. The income statement would show $10 million; the balance sheet would show $1 million. The cash flow statement would show $9 million in dividends distributed.
Preferred stock dividends are deducted on the income statement. The reason is that preferred stockholders have a higher claim to dividends than common stockholders. Many companies include preferred stock dividends on the income statement; then, they report another net income figure known as "net income applicable to common."
Now, let's say a company earned $10 million after taxes and paid $1 million in preferred stock dividends. The net income applicable to common would show only $9 million on the income statement.
Understanding the Nature of Preferred Stock
In essence, preferred stock acts like a mixture of a stock and a bond. Each preferred share is normally paid a guaranteed, fairly high dividend. If the company ever goes bankrupt or is liquidated, preferred stock is ranked higher in the capital structure to receive any leftover distributions. It's behind the bondholders and certain other creditors.
In exchange for this higher income and relative safety, preferred stock is not entitled to share in the business's success beyond the dividend. That's unless it is a special type, known as participating preferred stock. Even then, it won't be comparable to common stock. Rather, in a highly successful enterprise, as long as things go well year after year, you collect your preferred dividends. But the common stockholders earn significantly more.
Preferred stockholders may or may not have voting rights.
Some companies issue many different types of preferred stock all at once. These may include adjustable-rate preferred stock; convertible preferred stock; first preferred stock; participating preferred stock; participating convertible preferred stock; prior preferred stock; and second preferred stock.
Each preferred share may have different dividend rates or par values. So, before finding the "true" net income, dividends from all of these shares need to be deducted from net income on the income statement.
That is because, in nearly every instance, corporation bylaws forbid the payment of any dividend on the common stock. This is true unless the dividend on the preferred stock has been paid.
Let's look at it from the perspective of a common stock investor. The preferred stock dividends are required payments that must be made before it becomes possible to take some of the business earnings and enjoy them. Preferred stock dividends are every bit as real of an expense as payroll or taxes.
The Bottom Line
Preferred stocks have stability without the potential payout of common shares. This stability comes from being first in line for dividends. It also means that firms include preferred stocks on income statements.