A cumulative preferred stock is a type of preferred stock wherein the stockholders are entitled to receive cumulative dividends if any dividend payment has been missed in the past. When a corporation is not able to pay dividends for a particular year, they get accrued. This accrual process will continue till the date of payment.
What is a Cumulative Preferred Stock?
It is a type of preference share with a caveat that if any dividend payment was missed in the past due to a lack of sufficient profits, it should be paid first to the preference stockholder in the subsequent periods when there are adequate profits. In order of seniority, settlement of these types of shareholders takes place before other preference shareholders and common stockholders in an unfortunate event of liquidation.
- What is a Cumulative Preferred Stock?
- Cumulative Preferred Stock – An Example
- Cumulative Preferred Stock vs. Common Stock
- Cumulative Preferred Stock vs. Debt (Bonds or Debentures or Loan)
- Advantages of Cumulative Preferred Stock
- Disadvantages of Cumulative Preferred Stock
- Dividend Formula
- Accounting Treatment
The dividend on these types of stocks accrues even if the company does not declare any dividend in a particular year, unlike the non-cumulative preference stock, where the payment is dependent on the declaration of dividend. Preferred stock is presumed to be cumulative until and unless specified.
Cumulative Preferred Stock – An Example
If a company issues a cumulative preference share with a par value of $1000 and the annual dividend rate is 8%, the next year, the market conditions worsen. And the company decides to pay half of the dividend accrued and pays $40. If the next year’s situation fails to improve and the company cannot pay the dividend at all, the total amount the company now owes to a preferred stockholder is $120. But, if the following year’s situation improves and the company decides to pay the dividend. The preferred stockholders must be paid $120 in arrears along with the current year dividend of $80. Once all cumulative preferred stockholders are paid $200, the company may begin to pay other shareholders. Following is the tabular expression of cumulative dividends in preferred.
|Year 1||Year 2||Year 3|
Cumulative Preferred Stock vs. Common Stock
The primary difference between the two is the obligation to pay a dividend. It is not obligatory for the management to pay the dividend to common stock. Whereas the company can delay or partly pay the dividend in the case of cumulative preference share but cannot completely avoid it. In a profit-making corporation, equity stockholders are at an advantage as they get dividends or capital appreciation based on the corporation’s profits. In contrast, the preferred stockholders would get the fixed rate of dividend irrespective of the business’s profitability.
Cumulative Preferred Stock vs. Debt (Bonds or Debentures or Loan)
The company can delay or partly pay the dividend, but the obligation to pay a dividend is fixed in cumulative preference shares. Whereas the payment of interest in case of any debt is compulsory in the accrual year. If it delays such payments, the corporation can fall under the definition of bankruptcy.
Advantages of Cumulative Preferred Stock
- This type of preferred stock provides investors with security, and their investment is less likely to suffer volatility in the longer term.
- They are a comparatively secured investment. Since they do not lose the dividend on account of poor performance by the company in a particular year, the investors are more assured of their returns.
- Ranked higher to common stock in case of insolvency.
- Since these instruments allow dividends to cumulate, the rate offered to them vis-à-vis their Non-Cumulative counterparts is much lesser. Hence these instruments help companies to bring down their cost of equity.
- The management achieves the benefit of the flexibility of dividend payment and financial leverage, which results in the wealth maximization of its equity shareholder.
Disadvantages of Cumulative Preferred Stock
- The dividend rates remain stagnant in these types of stocks, i.e., they will receive the same dividend rate irrespective of the business profitability. They are just named as shareholders but do not have a share in profits in a true sense.
- At the time of its issuance, the dividend rates are more than the current prevailing interest rates to win investors’ preference over debt investments. In a rising interest rate situation, the investment in these stocks loses charm. On the contrary, if the interest rates fall, they become a good investment.
- Although the preference shares fall under equity, these stockholders do not enjoy voting rights.
- Their value hardly rises in such a scenario since the other bonds with higher yields are available.
- These types of stocks are subordinate to bonds, and hence in case of insolvency, they get a ranking after bondholders.
- Most of these stocks have a call feature, though with some call protection, which is a significant risk if the interest rate falls in a medium to a long-term time frame.
- Dividends are fixed obligations like interest on the debt. The only difference between a debt obligation and preferred stock is that the company can delay the payment of the preference dividend, but it cannot delay interest payments.
- They are a costly source of finance in comparison to debt.
See how to calculate the Cost of Preferred Stock to a corporation.
The formula for calculating the dividend in these instruments is as follows:
Annual Dividend = (Rate)*(Par Value)
If the payment frequency is quarterly, the dividend paid every quarter is
Quarterly Dividend = (Annual Dividend) / 4
If the company misses payment 3 times, then the arrears would be
Dividend Arrears = 3*(Annual Dividend)/4
So, Total Dividend Accrued (to be paid) = 3*(Annual Dividend)/4 + (Annual Dividend) / 4
The cumulative preferred stock appears in the stockholder’s equity on the balance sheet, and sometimes it is also mentioned in the notes to the balance sheet.
As far as the sequence of dividend payments is concerned, as per the accounting procedures, the arrears should be paid first and then the current year’s dividend payments. Hence the logic is to start with the oldest pending payment and move toward the latest.