Cumulative Preferred Stock: Definition, Feature, And How Does It Work?

Definition

Cumulative Preferred Stocks are a type of preferred stock that abides the company to pay all the dividends for this type of shareholders before paying any other shareholder of the company.

This means that the company is supposed to pay all the dividends, including the ones that were previously not paid out, to these cumulative preferred shareholders.

Therefore, the distinctive attribute of cumulative preferred shares is the fact that they are paid on a top priority basis, before any other subcategory of shareholders.

Similarly, in the case of cumulative preferred shares, dividends are accumulated and carried forward from one year to the next.

This means that in the case where the company is unable to issue dividends for a particular year, other shareholders simply miss out.

However, cumulative preferred shareholders get their dividends in a cumulative manner. Hence, they get paid their dividends, whenever the company issues dividends for other shareholders.

Similar to other preference shareholders, cumulative preferred stockholders do not have any voting rights. They are just entitled to their dividends at end of the year and have no say in how the company works.

Features of Cumulative Preferred Stocks

Cumulative Preferred Stocks are considered one of the most popular equity financing sources for the company. They have the following salient features:

  • This category of shareholders is entitled to dividends for a particular year – regardless of the fact that the company has declared dividends for the particular year or not.
  • Preference Shareholders have no right to vote – in other words, they cannot choose how the company runs, and who runs the company.
  • They are considered to be a long-term source of finance, which does not have a maturity date, and hence, the amount raised by selling cumulative preferred shares does not have to be paid back.
  • They have a fixed rate of dividend, which needs to be paid out irrespective of the volume of the profit that the company makes.
  • Cumulative Preferred Stockholders are entitled to their preferential right to receive dividends.
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How do Cumulative Preferred Stocks work?

Companies often issue cumulative preferred shares as a source of long-term financing that helps the companies to raise considerable finance.

In this regard, it is also imperative to consider the fact that cumulative preferred stock, cumulates all dividends payable.

If the company does not generate profit and is unable to pay dividends for one particular year, they are treated as years and are supposed to be paid out to the cumulative preferred stockholders, once the company is in a position to issue dividends.

The reason why companies prefer cumulative preferred stock is mainly rationalized by the fact that it does not alter the common shareholding of the company.

Since they have no voting rights, the inclusion of these shares often means that the company is able to raise finance, without altering the existing decision-making structure within the company.

Traditionally, cumulative preferred stocks have a stated dividend yield that is based on the par value of the share. This dividend is payable quarterly, semi-annually, or annually.

Preferred stock valuation is similar in nature to bond valuation. However, stock proceeds from issuing cumulative preferred shares are considered to be an asset.

Advantages of Cumulative Preferred Stock

As mentioned earlier, it can be seen that cumulative preferred shares are considered a relatively convenient means of raising finance for the company. Furthermore, it holds the following benefits for the company:

  • The amount raised via preference shares does not have to be repaid back – this means that the company can generate finance without having to worry about repayment of the principal.
  • Once the company has undertaken an IPO, and has sufficient authorized share capital, issuing new cumulative preferred shares is not a tedious job.
  • Cumulative Preferred Stock is a low risky investment from the perspective of investors – therefore, investors are readily prepared to invest in the company in the form of cumulative preferred stock.
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Limitations of Cumulative Preferred Stock

Regardless of the fact that cumulative preferred stock is considered to be one of the primitive sources of long-term financing for the company, yet it can be seen that it has certain limitations that cannot be overlooked.

Firstly, it can be seen that the dividend has to be paid out to cumulative preferred stockholders, regardless of the financial position of the company.

In case the dividend is not paid out in a particular year, it is accumulated and carried forward to the next year.

Therefore, it is a liability that a business has to undertake. In the same manner, dividends are not exempt from tax.

This implies that in the longer run, the cumulative preferred stock might prove to be a slightly expensive option, as compared to debt financing.

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