What Is Cumulative Dividend?
A cumulative dividend is a feature of certain preferred stock issues that ensures any missed or unpaid dividends from prior periods must be paid to shareholders before any dividends can be distributed to common stock shareholders. This characteristic offers enhanced protection to investors holding cumulative preferred shares, making them a significant consideration within corporate finance and investment decisions. The cumulative dividend stands in contrast to non-cumulative dividend preferred stock, where skipped payments are typically lost permanently.
History and Origin
The concept of preferred stock, with its unique dividend entitlements, evolved to offer a hybrid security that combines features of both equity and debt. The cumulative dividend feature emerged as a mechanism to provide greater assurance of income for preferred shareholders, particularly in times when a company might face financial difficulties. This protective clause helps to mitigate the risk for investors who prioritize stable income streams over capital appreciation, a common characteristic of preferred securities. Preferred stock, as a class of shares, is designed to give holders priority in receiving dividend payments and other benefits over common stock.5 According to Investor.gov, a resource from the U.S. Securities and Exchange Commission, preferred stock aims to offer certain investors the "best of both worlds" due to its blend of bond-like income features and equity ownership.4
Key Takeaways
- A cumulative dividend ensures that all missed preferred stock dividends accrue and must be paid before common shareholders receive any distributions.
- This feature provides an added layer of security for preferred shareholders, particularly income-focused investors.
- Unpaid cumulative dividends are referred to as dividend arrears.
- Companies with cumulative preferred stock face a strong incentive to clear any arrears to resume payments to common shareholders.
- The cumulative dividend affects a company's capital structure and cash flow management.
Interpreting the Cumulative Dividend
The presence of a cumulative dividend feature is a critical aspect for investors assessing preferred stock. When a company's board of directors decides to suspend dividend payments, typically due to financial strain, the cumulative clause means that the obligation to pay these dividends does not disappear. Instead, these unpaid dividends accumulate over time as arrears. For investors, this signifies a stronger claim on future corporate earnings compared to holders of non-cumulative preferred shares, who would lose any skipped dividend payments. The existence of significant dividend arrears can indicate financial distress, but also represents a substantial future liability for the issuing company that must be settled. Understanding this feature is key for shareholders evaluating the security and the issuer's financial health.
Hypothetical Example
Consider XYZ Corp. which has issued 100,000 shares of 5% cumulative preferred stock with a par value of \$100. This means each share is entitled to a \$5 annual dividend (5% of \$100).
In Year 1, XYZ Corp. pays the full \$5 per share dividend.
In Year 2, due to an economic downturn, XYZ Corp. faces cash flow issues and decides to skip the preferred dividend payment.
In Year 3, XYZ Corp. still cannot pay the dividend.
In Year 4, the company's financial situation improves, and it wishes to resume dividend payments, including paying dividends to its common shareholders.
Before common shareholders can receive any dividend, XYZ Corp. must first pay the accumulated cumulative dividends to its preferred shareholders. The arrears for Year 2 and Year 3 amount to \$5 per share for each year, totaling \$10 per share. Therefore, in Year 4, XYZ Corp. must pay:
- Year 2 arrears: \$5 per share
- Year 3 arrears: \$5 per share
- Year 4 current dividend: \$5 per share
This amounts to a total of \$15 per share (\$10 arrears + \$5 current) that must be paid to preferred shareholders before any common stock dividends can be declared or paid. This ensures the preferred shareholders eventually receive all their promised payments.
Practical Applications
Cumulative dividends are primarily found in preferred stock issuances and serve several practical purposes in the financial markets and investment strategy. For companies, issuing cumulative preferred stock can be a way to attract investors seeking stable income, especially when the company might experience fluctuating earnings. It signals a stronger commitment to preferred dividend payments, potentially lowering the required dividend yield compared to non-cumulative preferred shares. From an investor's perspective, cumulative dividends offer a layer of protection, as missed payments accumulate and must eventually be settled. This makes them appealing to institutions and individuals who rely on regular income, such as pension funds or retirees. The tax treatment of dividends, including those from preferred stock, is also a crucial application point. The Internal Revenue Service (IRS) provides guidance on how dividends are classified and taxed, with qualified dividends often receiving more favorable rates.3
Limitations and Criticisms
While cumulative dividends offer benefits to preferred shareholders, they also present certain limitations and criticisms. For the issuing company, the accumulation of dividend arrears can become a significant liability on the balance sheet, potentially hindering future financing or investment opportunities. Until these arrears are paid, the company is often restricted from paying dividends to common shareholders, which can frustrate common stock investors and impact the company's stock price. In extreme cases, substantial arrears can even lead to a company's liquidation if it cannot recover financially. From an investor's standpoint, while the cumulative feature ensures eventual payment, there is no guarantee when these arrears will be paid. If a company remains in financial distress for an extended period, the investor might face a prolonged wait for their dividends. Moreover, preferred stock generally does not offer the same capital appreciation potential as common stock.2 An academic analysis of preferred stock outlines various features and risks, including the potential for dividend deferral, which is inherent even in cumulative preferred shares, and their subordination to senior debt in a company's capital structure.1 As Reuters has reported, preferred stock can be a "tricky beast" for investors, highlighting the complexities beyond their seemingly stable income.
Cumulative Dividend vs. Non-cumulative Dividend
The primary distinction between a cumulative dividend and a non-cumulative dividend lies in the treatment of missed payments. For cumulative preferred stock, if a company fails to pay a dividend, that missed payment accrues as an outstanding liability (dividend arrears). The company must settle all accumulated arrears before it can pay any dividends to its common shareholders. This offers a stronger protection for the preferred shareholder's income stream. In contrast, with non-cumulative preferred stock, if a dividend payment is skipped, that payment is simply lost and does not accumulate. The company is under no obligation to pay past missed dividends to non-cumulative preferred shareholders before distributing current dividends to common shareholders. This makes non-cumulative preferred stock generally riskier for income-seeking investors, as their dividend payments are less assured.
FAQs
Q: Why do companies issue cumulative preferred stock?
A: Companies issue cumulative preferred stock to attract investors who prioritize a stable and predictable income stream. The cumulative feature signals a stronger commitment to paying dividends, which can make the preferred shares more appealing, especially when a company's earnings might fluctuate. It also helps companies raise equity capital without diluting the voting rights of common shareholders.
Q: What happens if a company goes bankrupt with cumulative preferred stock?
A: In the event of bankruptcy or liquidation, cumulative preferred shareholders have a higher claim on the company's assets than common shareholders, but they rank below bondholders and other creditors. Any accumulated dividend arrears would be part of their claim, which would be settled before common shareholders receive anything, but only after all senior debt obligations are met.
Q: Are cumulative dividends guaranteed?
A: No, cumulative dividends are not guaranteed in the same way that bond interest payments are. While the company is obligated to pay any missed cumulative dividends before paying common shareholders, it does not guarantee the company will always have the financial capacity to make those payments, or when they will be made. The obligation to pay exists, but the timing and certainty of payment depend on the company's financial performance and decisions.
Q: How do cumulative dividends affect a company's financial statements?
A: Unpaid cumulative dividends, or dividend arrears, are typically disclosed in the footnotes to a company's financial statements and do not appear as a liability on the balance sheet until they are formally declared. However, their existence represents a contingent liability and a significant claim on future retained earnings, impacting the company's ability to distribute profits to common shareholders.