What is cumulative preferred stock?
Cumulative preferred stock is a type of stock that has a provision mandating a company to pay all missed or outstanding dividends to cumulative preferred stockholders first. This has to be done before other forms of preferred stock shareholders and common stock shareholders can receive their dividends. Cumulative preferred stock is also referred to as cumulative preference shares.
A cumulative preference share is a type of preferred stock. Typically, preferred stock has a fixed dividend yield based on the par value of the stock. The payment of dividends takes place at set intervals which is usually on a quarterly basis to preferred stockholders.
There may be situations whereby a company runs into financial challenges and is unable to meet all of its obligations. In this case, it may suspend its dividend payments and concentrate more on paying expenses that are business-specific and debts. When the company gets out of trouble and starts paying dividends again, standard preferred stockholders do not have any right to receive any missed dividends. These standard preferred shares are the ones we refer to as non-cumulative preferred stock.
Therefore, cumulative preferred stock is different from non-cumulative preferred stock in which the company does not issue unpaid or omitted dividends. By implication, if dividend payments did not take place in a particular quarter or year, then these shareholders will simply miss out.
On the other hand, cumulative preferred shareholders will receive dividends in arrears before other shareholders receive a payment. This implies that common stockholders have to wait until all cumulative dividends are paid up before they receive any dividend payment again. In other words, a corporation that has cumulative preference shares will have to pay all outstanding dividends or dividends in arrears before it can pay any dividends to common stockholders.
If the company is not able to pay its preferred dividends in a given year, then they are carried forward to future years until the company is able to yield enough profit to pay them. It is for this reason that cumulative preferred shares usually have a lower rate of payment than the slightly riskier non-cumulative preferred shares.
Cumulative preferred stock examples
The term cumulative preferred stock can be better understood with examples. Let us look at the following;
ABC has a 10% cumulative preferred stock at $1 each valued at $ 1 million in 2019. By implication, the company will pay a $100,000 dividend every year, that is 10/100 x 1,000,000. It also has ordinary shares worth $5 million. It successfully paid up dividends for 2019 and 2020. However, due to some errors in production, the company made a loss and was unable to pay dividends in 2021.
This implies that the company will not pay dividends to all shareholders no matter their level. In 2022 however, the company was able to go back to its initial financial state and earn good profits. On the basis of the agreement, the cumulative shareholders will receive their payment of dividend arrears for the previous year, that is $100,000, and the dividend of 2022 which is also $100,000, making a total of $200,000 dividends.
For example, Company XYZ issued cumulative preference shares with a par value of $10,000 and the annual payment rate was 6%. Due to an economic downturn, the company was only able to afford to pay half the dividend it owed the cumulative preferred stockholder, $300 per share. The next year, the economic situation became worse and the company could not pay dividends at all.
It then owed the shareholder $900 per share. In the third year, there was an economic boom that allowed the company to resume dividends. In this case, the cumulative preferred stockholders must receive $900 in arrears in addition to the current dividend of $600 as of that time. As soon as all the cumulative preferred shareholders receive the $1,500 per share, the company may consider making dividend payments to other classes of shareholders.
Advantages of cumulative preferred stock
- With regard to financial safety, the cumulative preferred stocks are safe and secure compared to all other stocks available in the market. The reason is that the cumulative preferred stockholders will always get their dividends regardless of the bad performance of the company.
- These stockholders have the privilege of getting their dividends before every other stockholder in the company.
- In the case of an unpleasant situation of liquidation of the company, the cumulative preferred stockholders will get settled at the earliest, unlike other stockholders.
- In case of financial failure, the cumulative preferred stockholders may have the right to demand their dividends.
- If the company fails to pay dividends at the time it should, the dividends will be accumulated in accounts and paid afterward to the cumulative preference shareholders when things go normal for the company.
- Such stockholders may get a higher rate of return if the company experiences a good year.
Disadvantages of cumulative preferred stock
- The greatest disadvantage of cumulative preferred stock is that the shareholders do not enjoy voting rights compared to other stockholders.
- Such shareholders will always have a fixed dividend regardless of the profit that the company earns during the year. This is in contrast to other shareholders that will get the dividend payment based on the company’s profits.
- The cumulative preferred stock is more costly than other stocks that are available in the market since it possesses some extra privileges.
- The shareholders may receive partial or delayed dividend payments from the company.
- It is not possible for these stockholders to claim dividends in the middle of the year. They are not allowed interim dividends, they only get yearly payments.
Dividends in arrears on cumulative preferred stock
Dividends in arrears are usually associated with cumulative preferred stock. These are dividends that the company was unable to pay at the expected date. These dividends have not gotten authorization from the board of directors because the issuing company or entity has insufficient cash to make the payment.
It is possible for dividends in arrears to pile up over several subsequent dates if the company is faced with financial circumstances that do not allow for these payments. During this period, the market price associated with preferred stock is likely to decline since the dividend payments represent the main source of value for preferred stockholders.
If there is an improvement in the situation, then the board of directors will authorize that a portion or all these dividend payments be made. Once the authorization takes place, these dividends will appear on the company’s balance sheet as a short-term liability. Once the payment takes place, dividends in arrears go to the current holders of the related stock. There are no payments made to the person or entity that held the stock at the time in which the dividends were in arrears. Instead, it is only the new holders that benefit from these payments.
The fact that dividends in arrears exist is a concern to common stockholders since they are not entitled to any dividends until the company pays the full amount of the dividends in arrears to the cumulative preferred stockholders. This is because it can eliminate all dividends to common stockholders for an extended period of time.
FAQs on cumulative preferred stock
What is the difference between cumulative and non cumulative preferred stock?
One major difference between cumulative and non-cumulative preferred stock is that while the cumulative preferred stockholders are entitled to missed dividends or dividends in arrears, non-cumulative stockholders are not. In other words, if a company is unable to pay dividends due to unfavorable circumstances, when it comes back to its initial financial position, non-cumulative preferred stockholders will miss out on receiving dividends in arrears.
What does cumulative preferred stock offer?
The cumulative preferred stock offers dividends in arrears to its holders.
How do you calculate cumulative preferred stock?
To calculate dividends for cumulative preferred stock, it is necessary to first add the missed dividends to the current dividends. that is;
Cumulative dividend = Next quarterly dividend payment + postponed dividend payment
Is preferred stock always cumulative?
There are different types of preferred stocks and cumulative preferred stock is one of them. Therefore, preferred stock is not always cumulative.