In the case of cumulative preferred shares, the issuing company has to keep track of and pay out dividends first to preferred shareholders in the event dividends were not paid for previous years. If the company later begins to pay dividends again, shareholders with cumulative preferred shares will receive all prior missed dividend payments before common shareholders can receive theirs. Holders of non-cumulative preferred shares, on the other hand, have no right to receive past dividends should the company begin to issue dividends again. The company can also begin paying common stock dividends if it so chooses – as long as it is current with its cumulative preferred shareholders.
If a company issuing shares decides not to pay dividends, and you have cumulative preferred shares, you are entitled to receive these past dividends. However, if you own non-cumulative preferred shares, you cannot receive past dividends on your shares.
Definition of Preferred Stock
Preference, or preferred, stock is called that because it carries a legal claim that is superior to common stock on the underlying earnings and assets of its issuer company if that company is liquidated as a result of bankruptcy.
Preferred stock dividends are set when the issue is first priced and are fixed for the life of the security unless there is a provision to the contrary. The payment of preferred stock dividends takes place prior to the payment of dividends to common stockholders because preferred stock legally sits ahead of common stock in rights to the company's assets. However, preferred stock normally does not have voting rights.
Cumulative Preferred Stock
If financial problems beset a company, causing it to lose money, it can't pay its dividend obligations to its preferred and common stockholders. For holders of cumulative preferred stock, the dividends owed continue to accumulate until they are paid. All dividends owed to holders of cumulative preferred shares must be paid before holders of straight, or noncumulative, preferred and common stock can receive dividends. Straight, noncumulative preferred does not accumulate unpaid dividends, but its dividends are paid ahead of common stock, after any accumulated dividend obligations have been paid to holders of the cumulative preferred. Common stock dividends get paid last. Cumulative preferred also ranks higher than noncumulative preferred in the event of liquidation of company assets.
Other Types of Preferred Stock
Cumulative preferred stock always takes precedence over noncumulative preferred and common dividends, but there may be different levels of cumulative rights, such as first or senior cumulative preferred, which has preference over the regular cumulative preferred. There can also be a subordinated cumulative preferred, which is paid after the regular cumulative preferred dividends or asset liquidation is satisfied.
Exploring Pros & Cons
Cumulative preferred ranks above noncumulative preferred in terms of investment security, so it trades rich to the market for noncumulative preferred. Trading rich means its dividend rate of return is lower and it may have a higher credit rating assigned to the issue compared with that of the noncumulative preferred of the same issuer. A company issues a cumulative preferred so it can price its dividend lower than the market rate for noncumulative preferred. Investors seeking low-risk investments will accept a lower dividend rate in return for the promise of assured dividend payments and first call on company assets in the event of liquidation.
Video of the Day
- Accounting Coach: Preferred Stock
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- AccountingforManagement.org: Cumulative and noncumulative preferred stock
- Investopedia: Noncumulative
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