Dividends can provide you with an income from your investments while you are holding stocks. But a dividend is more than just a source of income for investors. Dividends have an effect on the firm's finances, including the amount of stockholders' equity in the company.
Stockholders' equity is listed on the balance sheet alongside the company's assets and liabilities. Simply put, stockholders' equity is the sum of profits that can be returned to investors or reinvested in the company. You can calculate the stockholders' equity of any company by simply subtracting the company's assets from its liabilities.
Dividends are paid to stockholders out of the firm's assets. Normally dividends are paid using cash assets, but dividends can be paid in the form of property such as stock in another company held by the firm issuing the dividend. A dividend can only be issued if there is an excess of assets over liabilities -- that is, if the stockholders' equity is positive. The decision of whether or not to issue a dividend is made by the company's board of directors.
Dividend Effect of Stockholders' Equity
Because dividends are paid out of assets, paying out a dividend naturally causes assets to decline. And because stockholders' equity is equal to assets less liabilities, any decline in assets causes an equal decline in stockholders' equity. For example, if a dividend is issued totaling $40,000, then assets would decline by $40,000, as would stockholders' equity. So if stockholders' equity had been $100,000 it would now be $60,000.
Other Causes for Change in Stockholders' Equity
Dividends are only one cause for a change in stockholders' equity. Stockholders' equity can also change due to net income. If the firm has net profits, this causes the company's assets to increase over its liabilities, leading to an increase in stockholders' equity. If the firm has net losses, then liabilities increase over assets, leading to reduced stockholders' equity. Stockholders' equity also increases when stock is issued, because the stock is traded to investors for cash, which increases the company's assets.