Cumulative preference shares give shareholders the right to receive cumulative dividend payouts from the company even if they are not profitable. These dividends will be counted as arrears in years when the company is not profitable. And will be paid in full from the year when the business is profitable.
Let’s understand the concept with the help of an illustration:
A company issues cumulative preference shares worth Rs 1,000 each, promising a 10% annual dividend. The economy and the company is in good financial health in year one, and the company pays the dividend in full. Thus, the cumulative preferred shareholder receives Rs 100.
However, the economy slows in year two, and the company can only afford to pay out half the dividend, or Rs 50.
The business environment further deteriorates in year three, and the company suspends dividend payments. The total amount owed to the shareholder has now increased to Rs 150. (Rs 100 for third year and balance Rs 50 from the second year).
In year four, the economy recovers, and dividend payments resume. The company must pay to cumulative preferred shareholder Rs 150 in arrears plus a Rs 100 dividend for the fourth year. Before the company can pay a dividend to other classes of shareholders, the company shall pay to cumulative preferred shareholders.
The following are the benefits:
- The company can postpone the payment of dividends in the case of these shares. It does not create any burden on the finances of the company.
- These shares do not create a mortgage or charge on the company’s assets. The company can keep its fixed assets free for future loan raising.
- The company pays a fixed rate of dividend on these shares.
- In general, these shares do not have voting rights. Thus, a company can raise capital without losing control. The company remains under the ultimate control of its equity shareholders.
Frequently Asked Questions
A preference share is a type of equity share that has debt instrument characteristics such as fixed income in the form of assured dividends. When the company declares dividends, preference shares give the buyer preference over common equity shareholders.
Preference Shares2 can be cumulative or non-cumulative. The former gives shareholders the right to receive cumulative dividend payouts from the company even if they are not profitable. That dividend payout can be made at some later point of time.
Cumulative Preference shares entitle an investor to missed dividends in the form of arrears of dividend. On the other hand, non-cumulative shares do not entitle an investor to missed dividends.
A cumulative dividend is a fixed distribution of earnings to shareholders that is required by law. These are the most common type of share class that allows for the payment of cumulative dividends.
Preference shares have characteristics of debt that provide owners with preferential rights in the event of a dividend payment or the company’s liquidation.