2.6: Financial Claims Hierarchy
Lenders and owners have different claims on the company’s interests. There is a distinct hierarchy in which the corporation’s claimants get paid – in order from first to last:
Debtholders : They get paid first. This includes the interest on loans, and on the loan’s principal when due. Loan payments are made as contracted, and do not increase should the firm become more profitable. Dividends may not be paid to shareholders unless loan payments have been made first, and in full.
Preferred shareholders : These owners (usually) get paid a fixed payment or “dividend,” which cannot increase even if the firm’s profits increase. If the firm is unable to pay the dividend it may skip it. However, most preferred dividends are “cumulative,” which means that no common stock dividends may be paid unless and until all past unpaid dividends that have accumulated “in arrears” are paid in full first.
Common shareholders : These shareholders get their dividends last, and are effective owners of any earnings, which the firm does not pay out, but “retains” and reinvests back into the firm in the manner of added property, plant, equipment, and working capital. In other words, common shareholders have a claim on the firm’s net income (after preferred dividends have been paid).
Common shareholders take on the most risk as they are last ones “on the totem pole.” Such is the case whether the firm is an ongoing enterprise or is being liquidated in bankruptcy. They get paid last. Common shareholders have a “residual” claim, or interest, in the company – after all other interests are taken care of.
On the other hand, the common shareholders have the most to gain if the firm is profitable; the dividend may be increased and more earnings may be retained – to their financial benefit, as the firm’s “retained earnings” are owned by the common shareholders.
Again, only common shareholders benefit if profits go up; common share ownership entails more risk, since if interest and preferred dividends are not paid, there may be nothing left for the common shareholders.
Government and Taxes : Let’s not forget that, after interest has been paid, the earnings of the company are then taxed, and that dividends are paid out of Net Income – after taxes have been paid. Taxes are a given, and normally, we do not think of the government as a claimant on the firm, since it is neither lender nor owner.
Nothing is certain except death and taxes.
-Benjamin Franklin