This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
After the amount of a corporation's net income has been determined, it is in order for the directors to consider how it shall be distributed. As was indicated in the preceding chapter, net income is distributed normally through three channels, which are respectively labelled: fixed charges, dividends, and additions to surplus.
As to "Fixed Charges" there is little that needs to be said at this point. They consist of taxes, payments on leases and rentals, and interest payments on the funded obligations. The amount of fixed charges (except for taxes) is determined by the amount and form of the company's capitalization and of its long-term contracts. We have already given consideration to the problems involved in drawing up a financial plan and in deciding what, if any, bond and note issues shall be put out. At the time when net income for a given period has been determined and its distribution is under advisement, the payments for fixed charges are no longer questions within the discretion of the directors or of any one else connected with the company. Unless they are paid as they become due, the company will at once cease to be solvent. We will assume, therefore, that net income is more than sufficient to meet fixed charges, and that there is remaining a balance available for dividends and surplus.
As to the distribution of this balance between dividends and surplus, the board of directors is the sole authority. Neither officers nor stockholders, as such, have any voice in the matter and there are few effective legal restrictions. We have before us, then, for treatment in this and in the following chapter, the two closely related questions:
What principles should guide the directors in fixing dividends?
What principles should guide the directors in accumulating and in using surplus?
Two classes of dividends are to be considered: those which are preferred and cumulative (with which may be included so-called interest on income bonds), and those which are common or ordinary and have no special priorities.
As to preferred dividends, much the same reasoning applies as has just been stated with regard to fixed charges. There is left, to be sure, a much larger measure of discretion to the directors, who may, at their option, decide to defer the payment. But there is a corresponding penalty in the fact that the accumulated dividends constitute a growing barrier in the way of common dividends, and that the credit of a corporation is adversely affected by piling up large arrears of preferred dividends. For these reasons corporations that are earning sufficient profits and are in sufficiently strong financial condition, usually pay their preferred dividends without much argument. There are, to be sure, some exceptions to this general statement, but the pressure in favor of payment of preferred dividends, wherever possible, is effective in the great majority of cases.
Preferred dividends which are not cumulative belong in a different class. The interests of the common stockholders, whom the directors usually represent, require that non-cumulative preferred dividends should not be paid until common dividends can also be paid. Hence we may include all dividend charges which have priority, but are not cumulative, tinder our consideration of common or ordinary dividends.