Non cumulative dividend

What Is Non cumulative dividend?

A non-cumulative dividend is a type of dividend associated with preferred stock where any unpaid dividends from prior periods do not accumulate. This means that if a company's Board of Directors decides not to declare a dividend in a given period, shareholders holding non-cumulative preferred stock will lose that dividend payment permanently. This feature is a crucial aspect of corporate finance as it directly impacts shareholders' potential returns and the company's obligations. Unlike its counterpart, a non-cumulative dividend offers no claim to missed payments in the future, providing the issuing company with greater flexibility in its dividend policy.

History and Origin

The concept of preferred stock, including its dividend features, emerged to bridge the gap between traditional common stock and debt financing. Early preferred shares, dating back to the mid-19th century in the United States, such as those issued by the Pennsylvania Railroad Company, sought to offer investors a more secure income stream than common stock, along with a priority claim on assets during liquidation⁴. Over time, variations like cumulative and non-cumulative features developed to cater to different investor appetites and corporate needs for capital. The specific terms and rights, including whether dividends are cumulative or non-cumulative, are detailed in the issuing company's articles of incorporation or through specific preferred share rights agreements³. This evolution reflects a continuous effort to structure equity financing instruments that balance investor protection with corporate financial maneuverability.

Key Takeaways

• A non-cumulative dividend means that if a dividend payment is missed, it is permanently lost and does not accumulate.
• Holders of non-cumulative preferred stock have no claim to unpaid past dividends.
• This feature provides greater financial flexibility for the issuing company, especially during periods of low profitability.
• Non-cumulative dividends are primarily associated with preferred stock, which typically has priority over common stock for declared dividends.
• Understanding the non-cumulative feature is essential for evaluating the risk and potential return of certain preferred stock investments.

Formula and Calculation

A non-cumulative dividend does not involve a complex formula for calculating arrears because missed payments do not accrue. The calculation simply involves the stated dividend rate on the preferred stock's par value for the current period. If the Board of Directors declares a dividend, the payment for a given period is:

$\text{Dividend Payment per Share} = \text{Par Value per Share} \times \text{Dividend Rate}$

If the dividend is not declared for a period, the payment for that period is zero, and that missed payment is not carried forward to future periods. This differs significantly from cumulative preferred stock where unpaid dividends would accumulate as dividends in arrears.

Interpreting the Non cumulative dividend

The presence of a non-cumulative dividend feature significantly influences the risk profile and attractiveness of preferred stock to investors. From an investor's perspective, non-cumulative preferred stock carries higher risk compared to cumulative preferred stock because there is no guarantee of receiving missed dividend payments. Investors evaluating such securities must understand that if the company faces financial difficulties or prioritizes other uses for its retained earnings, dividend payments may be skipped without any future obligation to compensate for those omissions. This feature can impact the perceived stability of income and potentially lead to a lower dividend yield compared to cumulative preferred shares with similar characteristics, all else equal. Companies often issue non-cumulative preferred stock to maintain greater financial flexibility and reduce fixed obligations in their capital structure.

Hypothetical Example

Consider XYZ Corp. which has issued 1,000,000 shares of non-cumulative preferred stock with a par value of $100 per share and a stated non-cumulative dividend rate of 5%. This translates to an annual dividend of $5 per share ($100 \times 0.05).

In year 1, XYZ Corp. is highly profitable and declares and pays the full $5 per share non-cumulative dividend. Total dividend payout: $5,000,000.

In year 2, due to unexpected market conditions, XYZ Corp.'s profitability declines, and its Board of Directors decides not to declare any dividend on its preferred stock to conserve cash. Since the preferred stock is non-cumulative, the $5 per share dividend for year 2 is permanently lost to the shareholders. There is no obligation for XYZ Corp. to pay this missed dividend in the future.

In year 3, XYZ Corp. recovers and once again declares and pays the full $5 per share non-cumulative dividend. The shareholders receive their current year's dividend, but they do not receive the $5 per share dividend that was missed in year 2. This example highlights the direct consequence of the non-cumulative feature for investors.

Practical Applications

Non-cumulative dividends are often found in certain types of preferred stock issued by financial institutions, particularly banks. This is partly due to regulatory capital requirements, where non-cumulative preferred shares can be classified in a way that helps bolster a bank's regulatory capital. For example, some regulations may favor equity instruments that do not carry a fixed payment obligation, providing a buffer against financial stress. The Federal Reserve, for instance, details how dividends are treated for member banks, with some provisions addressing cumulative aspects². Additionally, companies looking to conserve cash during economic downturns or periods of significant investment may opt for non-cumulative preferred stock as a less burdensome form of equity financing. This allows the company more discretion over cash outflows without accumulating persistent liabilities from missed dividend payments. The general corporate dividend policy of a company can be a complex decision influencing firm performance¹.

Limitations and Criticisms

The primary limitation and criticism of a non-cumulative dividend feature revolve around the increased risk borne by the investor. For investors seeking stable income, the non-cumulative nature means there is no assurance of receiving all stated dividends over time. If a company skips a payment, that income is irrevocably lost. This contrasts sharply with the greater investor rights often associated with cumulative preferred stock, where missed payments are added to the company's liabilities and must be settled before common shareholders can receive any dividends. Critics argue that non-cumulative preferred stock offers less protection than other fixed-income-like securities, especially for investors prioritizing consistent income over potential capital appreciation or higher liquidation preference rights. The decision by a Board of Directors to skip a non-cumulative dividend can also be interpreted by the market as a sign of financial weakness, potentially impacting investor confidence and the company's future ability to raise capital.

Non cumulative dividend vs. Cumulative dividend

The fundamental difference between a non-cumulative dividend and a cumulative dividend lies in the treatment of missed payments.

With a non-cumulative dividend, if the company's Board of Directors chooses not to declare a dividend in any given period, the holders of these preferred shares forfeit that payment entirely. Conversely, for preferred shares with a cumulative dividend feature, any dividends not paid in a period become an accrued liability for the company. These accumulated, unpaid dividends must be fully paid to cumulative preferred shareholders before any dividends can be distributed to common stock holders. This distinction is paramount for investors assessing the income stability and investor rights associated with preferred shares.

FAQs

What is the main characteristic of a non-cumulative dividend?

The main characteristic is that if a company misses a dividend payment to non-cumulative preferred shareholders, that payment is permanently forfeited and does not accumulate.

Why would a company issue preferred stock with a non-cumulative dividend?

A company might issue non-cumulative preferred stock to gain greater financial flexibility. It reduces the fixed financial obligation, especially if the company faces periods of low earnings per share or needs to conserve cash for other purposes.

Are non-cumulative dividends common?

Non-cumulative dividends are less common than cumulative dividends but are often found in certain sectors, such as banking, due to specific regulatory or capital structure considerations.

What happens if a company with non-cumulative preferred stock skips a dividend?

If a company skips a non-cumulative dividend, the preferred shareholders do not receive that dividend for the period, and the company has no obligation to pay it in the future. This allows the company to retain more cash, which may impact its financial statements by increasing retained earnings.