Preferred Stock on an Income Statement

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New and experienced investors alike may be unable to explain what preferred stock is and how it factors into their valuation of a company's worth. Most investors are familiar with common stock, but preferred stock is a bit different, with qualities of both a stock and a bond.

Preferred stocks typically pay fixed dividends, which are distributions of company profits. Preferred stock dividends play a role in understanding income statements. Let's discuss the role of preferred stock on an income statement and how it influences the reported profit and loss in companies that have issued a large amount of preferred stock.

Preferred Stock Dividends and 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 represents the total after-tax profit the business made for the period prior to deducting the required dividends that were paid on the company's 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 ordinary common stock are not deducted from the income statement. In other words, if a company made $10 million in profit and paid $9 million in dividends, the income statement would show $10 million, the balance sheet $1 million, and the cash flow statement $9 million in dividends distributed.

Preferred stock dividends are deducted on the income statement. This is because preferred stockholders have a higher claim to dividends than common stockholders. Many companies include preferred stock dividends on the income statement and then report another net income figure known as "net income applicable to common." If 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, with each preferred share normally paid a guaranteed, relatively high dividend. In the event the company ever goes bankrupt or is liquidated, preferred stock is ranked higher in the capital structure, behind the bondholders and certain other creditors, to receive any remaining distributions from the windup or reorganization.

In exchange for this higher income and relative safety, preferred stock is not entitled to share in the success of the business beyond the dividend unless it is a special type known as participating preferred stock. Even then, the participation won't be comparable to common stock. Rather, in an extraordinarily successful enterprise, as long as things go well year after year, you collect your preferred dividends while 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. Preferred stocks may have different dividend rates or different par values. The dividends from all of these need to be deducted from net income on the income statement before arriving at the "true" net income.

That is because, in nearly every instance, corporation bylaws forbid the payment of any dividend on the common stock unless the dividend on the preferred stock has been paid. That is, 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 earnings out of the business 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, and it also means that firms include preferred stocks on income statements.