Cumulative Preferred Stock

Article byWallstreetmojo Team
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

What is Cumulative Preferred Stock?

Cumulative preferred stock is a class of shares wherein any unpaid or undeclared dividends for the current year must be accumulated and paid for in the future. However, such stocks are costlier, do not have voting rights, and cannot demand interim dividends.

Cumulative Preferred stockholders get a fixed dividend rate irrespective of the profit marginProfit MarginProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more; this means they are not participating in the company’s profits. The benefit of these stocks is that in case of a financial crisis, if the company cannot declare the dividend, then the dividend amount will accumulate and will get paid in the future whenever the company declares the dividendDeclares The DividendDividend declared is that portion of profits earned that the company’s board of directors decides to pay off as dividends to the shareholders of such company in return to the investment done by the shareholders through the purchase of the company’s securities.read more.

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Key Takeaways

  • Cumulative preferred stock guarantees that any unpaid dividends accumulate and must be paid in the future, providing financial security to shareholders even during challenging periods.
  • Holders of cumulative preferred stock receive a fixed dividend rate, regardless of the company’s yearly profits, ensuring predictable income but without the potential for increased dividends during prosperous years.
  • These stockholders have priority over common shareholders in receiving dividends and, in case of company liquidation, offering a level of safety and preference in financial matters.

Example

The company has not declared dividends in the last four years due to the financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more. For the last four years, the dividends for the cumulative preferred stockholders were $20 each year, which was unpaid.

The business in the 5th year was great, so the management declared a dividend to its shareholders. However, the company will have to pay $80 to the cumulative preferred stockholders first, and then they are allowed to distribute the dividends to the common shareholders.

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Advantages

Disadvantages

  • The biggest disadvantage is that they don’t enjoy voting rights compared to other stockholders.
  • Such shareholders will always get the fixed dividend irrespective of the profit earned during the year. In contrast, other stockholders will get the dividend payment per the company’s profits.
  • It is more costly than any other stocks available in the market since the cumulative preferred stock carries some extra privileges.
  • They may get partial or delayed dividend payments from the company.
  • The dividends are fixed, but in the case of any other stocks like debts, the management will have to pay the debt interest to the holder as well, and there cannot be any delay in the payment of the same.
  • These stockholders cannot claim dividends in the middle of the year. They are not allowed interim dividends; they are only paid yearly.

Frequently Asked Questions (FAQs)

1. What is the importance of cumulative preferred stock?

Cumulative preferred stock provides consistent income to shareholders. It ensures that if dividends are not paid in a particular period, they accumulate and must be paid in the future. This feature can attract risk-averse investors who seek reliable dividend payments and a degree of security.

2. What are the risks associated with cumulative preferred stock?

The company’s cumulative preferred stock represents a financial obligation that must be met even during challenging financial periods. Delays or failure to pay accumulated dividends can damage investor confidence and credit worthiness. However, for investors, the fixed dividend payments may not keep pace with inflation or changes in interest rates.

3. What is the difference between cumulative and non-cumulative preferred stock?

Cumulative preferred stock accumulates unpaid dividends and ensures their eventual payment, providing a measure of security to investors. Non-cumulative preferred stock does not accumulate unpaid dividends; if dividends are not paid in a period, they are lost. Non-cumulative preferred stock offers greater flexibility to the company but carries higher risk for investors.

This has been a guide to what is cumulative preferred stock. Here we discuss how it works, examples, advantages, and disadvantages. You can learn more about financing from the following articles –