Interest vs Dividend in Stocks

Oct 22, 2021 04:16 PM ET
Interest vs Dividend in Stocks

A dividend is a sum of money given out by a corporation to all of its shareholders from the profit it makes each year. Shareholders receive payments, which are often a fraction of the profits made, as opposed to the entire profit. Part of the profits is often injected back to support the company’s projects. 

On the other hand, interest is the fee that a borrower has committed to pay in addition to the principal loan amount. Interest payments by a company can, therefore, significantly impact its profitability and growth.

How dividends work 

Those who have preference stocks benefit from not only dividend payments but also voting rights.  For common stockholders, companies have the final say on whether or not to give them a share of the profits. 

It pays to invest in companies that issue dividends. Such companies use dividends as an incentive to their shareholders to continue holding on to their stock. In return, such shareholders enjoy regular payments from the companies, regardless of whether or not the company’s stock appreciates significantly in the stock market.  

The decision not to pay dividends to shareholders is usually driven by a motive to increase the financial stability of a company by reinjecting back the profit. The benefits are usually reflected in the stock market, where the company’s stock price rises as a result of a solid financial foundation. Investors are usually quick to buy such stocks because of their issuer’s financial stability, thereby propelling the prices higher. Therefore, investing in the stock of a company that doesn’t pay dividends can be quite profitable in the long term in terms of capital gains.  

How interest works

As long as you don't spend the money you've kept in a bank, you'll earn interest by putting it in a savings account. It is a fee based on the amount of money borrowed, to put it another way.

Interest rates can come from a variety of sources, including banks, lenders, and other organizations. They are simply the money that lenders receive in exchange for giving out a loan. Any company's net income is lowered by interest expense. 

Dividends vs. interest: the differences

Below are the key differences between dividends and interest.

  • You can only earn dividends when the company you’ve invested in generates a profit. Importantly, the company often exercises its own discretion in deciding whether or not to distribute its profits and what percentage to distribute. Dividends are usually distributed annually, but there are a few cases of quarterly distribution. In contrast, interests must be paid by companies servicing their loans, and they cannot choose not to do so. Interest payments are a matter of following strict legal procedures. The company has to pay its lenders and debenture holders when the payment schedule is due. Failure to do this may lead to legal trouble.
  • Interests are paid by borrowers to their creditors and they constitute their profit on top of the principal loan given. The loans are usually taken from financial institutions, who may not necessarily be shareholders in the company. In contrast, company dividends go to shareholders, who have a stake in the company and as part-owners.
  • Interest rate is predetermined. It is agreed upon at the time of contract beginning what percentage of interest will be charged on the principal amount. The dividend payout percentage can change depending on the company's strategy.
  • If you borrow money for your business, you must pay interest on that loan. Even if your company is losing money, you must pay interest on your loans. If the payment is not received within the specified time range, the corporation may be subject to legal action. Dividends, on the other hand, are determined by the Board of Directors, in line with a company's  objectives.

By looking at how a company has historically distributed its dividends, we can deduce a lot about its past and future performance. First, we can tell how much such a company has re-invested in itself by looking at the percentage of profits that is reinjected back. Secondly, we know that a company that pays dividends on a regular basis must have strong financial capabilities.

If a company is consistent in its payment of dividends, it indicates that it has strong fundamentals. This is usually an incentive to investors. It's possible to figure out how much money a business has made or lost based on its interest payments. The absence of interest payments in the financial accounts signifies the absence of debt in a company.

In summary

Dividends and interest, while distinct sources of income, are both critical to a company’s and investors’ success. They have earnings implications that should be considered before making any investment decisions. However, before drawing any conclusions, it's important to look at the company's historical performance and yearly financial records.

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