What is Cumulative Preferred Stock?
Definition: Cumulative preferred stock is a special type of stock class that accords shareholders some privileges when it comes to dividend payments. Proffered stock holdings come with a provision that requires companies to pay out dividends to stockholders even on suspending payments for some time because of financial challenges.
Cumulative preferred stock is essentially a special type of stock holdings that entitles investors to a certain dividend amount every year or accounting period. Any unpaid dividends or arrears accumulate and must be paid without failure at a future date. Whenever a company does not make any dividend payments, the unpaid dividends are said to be in arrears and must be disclosed in financial statements.
In addition, cumulative dividend payment accrues whether a company declares or does not declare dividend offering in a given year. Therefore, preferred stocks are always cumulative unless specified otherwise.
Preferred stock holdings differ from common stock holdings on the fact that shareholders are entitled to dividend payments regardless of what happens in a company. However, preferred stockholders don’t have voting rights that can allow them to control the destiny of a company.
In addition, preferred stockholders cannot demand a company to make dividend payments even though they are entitled to them. It is the responsibility of a company’s board of directors to make decisions on when dividend payments are to be made.
Understanding Preferred Stock
Public companies do experience financial problems that make it difficult for them to meet their financial obligations. In such scenarios, conservation of capital usually comes into play. A company in a financial quagmire may decide to suspend dividend payments until such a time when the financial position improves to support dividend payments.
Upon a company getting through the financial problems, it may commence dividend payments. However, dividend payments, in this case, are made with some preference. Owners of cumulative preferred stock must be paid first, all arrears that have accumulated over the period in which the suspension was in force, before other shareholders are paid.
Unlike cumulative preferred stockholders, standard preferred stockholders don’t poses any right to receive any missed dividend payments. In addition, standard preferred stockholders can only receive their fair share of dividends once all cumulative preferred stockholders are paid their fair share.
In case a company gets liquidated, cumulative preferred stockholders must be paid their fair share of dividend arrears before common stockholders get their share. Income focused investors are fond preferred stock holdings given the guarantee that the stock holdings comes with when it comes to dividend payments.
Likewise, preferred stocks behave like bonds given the guarantee that they come with when it comes to dividend payments. However, it is important to note that unlike the case with bonds, preferred stockholders don’t have a say on the amount of dividends that a company can pay.
Cumulative Preferred Stock Advantages
Cumulative preferred stock holdings come with the security that ensures their investments always generate dividends regardless of how a company performs. Investments, in this case, are less likely to suffer from volatility.
Similarly, preferred stockholders rank higher in a company when it comes to insolvency matters. In this case, their interests are always taken care of ahead of that of other investors.
Companies issue cumulative preferred stock offerings, given their low cost of equity. The cumulative aspect allows companies to offer lower dividend yields compared to what is offered to other stock classes.
Cumulative preferred stock holdings also offer management the flexibility when it comes to dividend payments.
Disadvantages of Cumulative Preferred Stock
Dividend rates with cumulative preferred stock tend to remain stagnant regardless of how a company performs a bid disadvantage in times of rising interest rates. In this case, investors can end up with lower payments, even on a company’s overall profitability improving significantly.
Cumulative preferred stockholders also don’t enjoy voting rights compared to non-cumulative stockholders.