Cumulative Preferred Stock

Definition

Cumulative Preferred Stock refers to a class of preferred stock where dividends accumulate if they are not paid out in a given period due to insufficient earnings or any other reason. These accumulated dividends must be paid to cumulative preferred shareholders before any dividends can be distributed to common shareholders. This “dividend in arrears” feature adds an additional layer of security for investors compared to non-cumulative preferred stocks, where omitted dividends do not accumulate.

Key Characteristics

Accumulation of Dividends: Dividends that are missed or deferred due to inadequate profits are accumulated.
Preference over Common Stock: Dividends must be paid to cumulative preferred shareholders before any dividends can be paid to common stockholders.
Priority in Liquidation: In the event of liquidation, cumulative preferred shareholders have a higher claim on assets than common shareholders.

Examples

Company X Issues Cumulative Preferred Shares: Suppose Company X issues cumulative preferred shares with a promised annual dividend of $5 per share. If the company fails to pay this dividend for three years, it owes $15 per share ($5 x 3 years) to its preferred shareholders before it can distribute any dividends to its common shareholders.
Financial Troubles: A company encountering financial trouble might skip dividends payments for a time. However, once financial health is restored, it must settle all accumulated dividends with cumulative preferred stockholders first.

Frequently Asked Questions (FAQs)

What happens if a company never earns enough to pay accumulated dividends?

If a company continually fails to earn sufficient profit to pay accumulated dividends to cumulative preferred shareholders, these dividends may remain unpaid. In cases of liquidation, preferred shareholders are prioritized over common shareholders for any remaining assets.

How do cumulative preferred stocks differ from non-cumulative preferred stocks?

Unlike cumulative preferred stocks, non-cumulative preferred stocks do not accumulate unpaid dividends. If a dividend is missed, it is lost forever, and the shareholder has no right to claim it in the future.

Are there any tax implications for dividends from cumulative preferred stocks?

Yes, dividends from preferred stocks, including cumulative ones, may be taxed as income. The specific tax treatment can vary depending on local tax laws and individual circumstances.

Can cumulative preferred stocks be converted to common stocks?

That depends on the specific terms of the issuance. Some cumulative preferred stocks are convertible, meaning they can be converted into a predetermined number of common shares.

Are dividends from cumulative preferred stocks guaranteed?

While dividends on cumulative preferred stocks are promised, they are contingent on the company’s earnings and financial health. There are no legal guarantees of payment unless specified in the company’s charter.

Preferred Stock: A type of stock that gives holders a higher claim on dividends or asset distribution than common shareholders.
Common Stock: Shares representing ownership in a corporation, giving holders voting rights and a residual claim on corporate earnings.
Dividend: A distribution of profits by a corporation to its shareholders.
Arrears: The term for unpaid and overdue obligations, such as cumulative dividends that have accrued but not yet been paid.

Online References

Suggested Books for Further Studies

“Investing in Preferred Stocks: An Introduction for Modern Income Investors” by Doug K. Le Du
“Preferred Stock Investing” by Doug K. Le Du
“The Intelligent Investor” by Benjamin Graham, specifically focuses on various investment strategies, including preferred stocks.
“Security Analysis” by Benjamin Graham and David L. Dodd for detailed insights into the valuation of securities, including preferred stocks.

Fundamentals of Cumulative Preferred Stock: Finance Basics Quiz

### Which type of stock prioritizes paying dividends to its holders before the payments to common stockholders? - [ ] Common Stock - [ ] Non-cumulative Preferred Stock - [x] Cumulative Preferred Stock - [ ] Convertible Notes > **Explanation:** Cumulative preferred stockholders' dividends must be paid first, particularly when dividends are in arrears, providing more security for these investors compared to common stockholders. ### What happens to missed dividends in cumulative preferred stock? - [ ] They are lost forever - [x] They accumulate and must be paid in future - [ ] They are transferred to common stockholders - [ ] They are added to the company’s retained earnings > **Explanation:** In cumulative preferred stock, missed dividends accumulate and must be paid out before any dividends can be disbursed to common shareholders. ### How does cumulative preferred stock affect a company during low-earning periods? - [ ] The company must pay dividends to all cost categories equally - [ ] The company can ignore all dividend payments - [x] The company accumulates dividend payments to preferred stockholders - [ ] The company pays common stockholder dividends first > **Explanation:** During low-earning periods, dividend payments to cumulative preferred stockholders accumulate and must be paid in arrears before any dividends are paid to common stockholders. ### What type of preferred stock does not accumulate unpaid dividends? - [ ] Common Stock - [x] Non-cumulative Preferred Stock - [ ] Convertible Preferred Stock - [ ] Treasury Stock > **Explanation:** Non-cumulative preferred stockholders do not collect unpaid dividends; these are forfeited if not paid. ### Which term describes dividend payments that are overdue and must be paid out eventually according to cumulative preferred stock agreements? - [ ] Insufficient Dividends - [ ] Overdue Claims - [x] Dividends in Arrears - [ ] Prior Payment > **Explanation:** "Dividends in Arrears" refers to overdue dividends on cumulative preferred stock that accumulate and must eventually be paid out. ### In liquidation, which shareholders get priority after paying off debts? - [ ] Common Shareholders - [ ] Creditors - [x] Cumulative Preferred Shareholders - [ ] Government Entities > **Explanation:** Cumulative preferred shareholders are prioritized for receiving payment after fulfilling the company’s debt obligations, ahead of common stockholders. ### Can dividends from cumulative preferred stock be guaranteed by companies? - [ ] Yes, always - [x] No, they are promised based on earnings - [ ] Only in financially robust companies - [ ] Guarantees can be implied but not enforced > **Explanation:** Dividends from cumulative preferred stock are promised, contingent upon sufficient earnings. They are not legally guaranteed unless specified otherwise. ### Are cumulative preferred dividends counted before or after common dividends? - [ ] After common dividends - [ ] Simultaneously with common dividends - [x] Before common dividends - [ ] Only when profits exceed usual levels > **Explanation:** Cumulative preferred stock dividends must be cleared before any dividends can be declared for common stock shareholders. ### Do cumulative preferred stocks ensure dividend accumulation during financial troubles? - [ ] No accumulation happens - [ ] Only during the first year - [x] Yes, until paid - [ ] Only with issued warrants > **Explanation:** During financial difficulties, cumulative preferred stock dividends accumulate ("dividends in arrears") and must be settled in full before common stockholders receive dividends. ### Why might an investor prefer cumulative preferred stock over common stock? - [x] Higher dividend security in uncertain times - [ ] Equal treatment in dividend payouts - [ ] Higher risk with potential higher returns - [ ] No difference other than voting rights > **Explanation:** Investors may prefer cumulative preferred stock for its higher dividend security, as cumulative preferred dividends must be settled even when missed in previous periods, ensuring predictable returns.

Thank you for exploring the detailed mechanisms of cumulative preferred stock and participating in our educational quiz. This deep dive helps in recognizing investment dynamics within the stock market, enhancing financial acumen.