Dividend-bearing stocks are very popular among a wide variety of investors, so when a company decides to suspend its dividend payments, it can be a signal to sell for many shareholders. Of course, those who own a stock primarily for the benefit of annual dividend payments are most likely to abandon ship. However, even investors who employ a buy-and-hold strategy may turn tail and run if a company that traditionally pays consistent dividends unexpectedly declares a suspension.

The following are the top four reasons a company may suspend its dividends. While this action can often be a sign of a struggling enterprise, not all dividend suspensions foreshadow corporate failure.

Key Takeaways

  • Many companies pay dividends as a way to return profits to investors.
  • Some companies, however, choose to retain earnings in order to fund new growth opportunities.
  • Companies may also suspend regular dividends in response to financial troubles or unforeseen large expenses.

Financial Trouble

The chief cause of a dividend suspension is the issuing company is under financial strain. Because dividends are issued to shareholders out of a company's retained earnings, a company that is struggling may choose to suspend dividend payments to safeguard its financial reserves for future expenses. If revenue is down or costs are up, the amount of money left over for dividends at the end of the year may be minimal or nonexistent. Sometimes, dividend suspensions may be announced out of necessity, meaning there is no profit to distribute, or out of proactive financial planning, meaning profit margins are not large enough to warrant any nonessential spending.

Unexpected Expenses

Another reason a company may suspend its dividends is due to unexpected one-time expenses that temporarily reduce profits. Even if revenues remain constant year to year, a lawsuit judgment against the company or the need to replace or update costly equipment may require the company to use its earnings for other purposes. In these scenarios, dividends are generally reinstated as soon as the unexpected expense is satisfied. Shareholders that jump ship at the first sign of trouble may be sacrificing future dividends and capital gains because they failed to research the cause behind the suspension. Not all dividend suspensions are cause for shareholder panic.

Funding Growth

Dividends are issued out of a company's retained earnings, which represents the total amount of profit accumulated over time that has not been previously distributed as dividends in prior years or otherwise used up. Outside of dividend payments, one of the primary uses for retained earnings is to fund growth projects that, while temporarily costly, promise to provide increased income in the future. If a company decides the time is right to open a new location, expand its product line or reach out to a new market segment, it may dip into its retained earnings to fund the growth. In this case, dividends may be suspended temporarily to facilitate increased earnings. Again, shareholders who dump a stock that suspends dividends to fund growth may be missing out on accelerated capital gains and increased dividends in future years.

To Defer Preferred Dividends

Dividend distributions can be a little complicated because there are two types of stock that a company can issue. Most stock is considered common stock, and dividends are issued at the discretion of the issuing entity. However, many companies also issue preferred shares that do not carry the same ownership rights as common stock but do provide a guaranteed dividend amount each year, which is typically higher than the dividend received by common shareholders.

To issue dividends to common shareholders, the company must first pay back any dividends due to preferred shareholders. In some cases, a company may have the funds necessary to pay a common dividend but not to pay both preferred and common dividends. In this case, a company may choose to pay preferred dividends but suspend common dividends or decide to suspend all dividends entirely.

However, any preferred dividends that are deferred must be paid before any common dividends can be distributed. In this case, common dividends may be suspended indefinitely so the company can afford to pay preferred shareholders. Companies that have to suspend preferred dividends fight an uphill battle against ever-increasing overdue payments in subsequent years, so this is not a popular choice unless the company is in serious trouble.