Preferred Stock on an Income Statement

Whether you're a new or experienced investor, you may have a hard time explaining what preferred stock is and how it affects 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, which 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 it.

How Does Preferred Stock Relate to Net Income?

An income statement is a type of financial statement. It includes a company's revenues, expenses, gains and losses, and net income, which is the total after-tax profit made for the period. It is calculated 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, because of the nature of preferred stock and its dividends. Regular cash dividends paid on common stock are not deducted from the income statement. For example, suppose a company made $10 million in profit and paid $9 million in dividends. The income statement would show $10 million, and 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 do. Many companies include preferred stock dividends on their income statements; then, they report another net income figure known as "net income applicable to common." 

Now, suppose 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 will be ranked higher in the capital structure to receive any leftover distributions but behind the bondholders and certain other creditors.

In exchange for this higher income and relative safety, preferred stockholders are not entitled to share in the business's success beyond the dividend, unless they hold 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 will collect your preferred dividends, but the common stockholders will earn significantly more. 

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 its own dividend rate or par value, 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 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 receive 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 that common shares have. It comes from being first in line for dividends. Firms include preferred stocks on income statements.

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