Cumulative Dividends: Everything You Need to Know
A cumulative dividend is a distribution made to the holders of special "preferred" shares regularly. It is unrelated to company profits.5 min read
What Are Cumulative Dividends?
If a dividend is sharing company profits to shareholders, then a cumulative dividend is a distribution made to the holders of special "preferred" shares regularly. It is unrelated to company profits.
Regular or "noncumulative" dividends are voluntary. This means the Board of Directors has the option of awarding them. This usually depends on how the company has performed each year.
However, paying cumulative dividends is mandatory. If the company can't pay out a cumulative dividend in any given fiscal year, the amount for that year is carried forward. It must always be paid out before any payments to common shareholders.
Not all "preferred shares" have the right to receive cumulative dividends. Some cumulative preferred shares carry limitations. For example, the company may only have to pay cumulative dividends if it liquidates. In addition, paying out cumulative dividends doesn't take preference over paying the company's creditors.
The owners of such preferred shares have a guaranteed return on their investment. In this way, cumulative preference shares combine finance (receiving interest on a capital investment) and equity (they are shares rather than loans).
Why Are Cumulative Dividends Important?
Preferred shares are attractive to investors. They protect their investment by providing a minimum rate of return.
Cumulative preferred shares often have higher rates of return than regular preferred shares. This is because there is some risk of payments being delayed. But why do companies issue cumulative preferred shares where they must pay out cumulative dividends?
Companies need to raise money to fund their business's operation and expansion. The two main options are either:
- Borrowing money (debt)
- Issuing and selling shares
Such equity issues come in different forms. It mainly depends on the relationship the company wants with its shareholders. It also depends on practical issues, such as how urgently the money is needed.
Cumulative dividends are not very common. In fact, they are offered in less than 10 percent of share offerings.
However, in some situations, they are considered useful in attracting investment while delaying dividends in the short term. Preferred shares are also appealing if the company wants to limit the shareholder's power of company decisions. This is because they do not come with voting rights.
How Do Cumulative Dividends Work?
A cumulative dividend is calculated each year, either as a fixed amount or as a percentage of the shares' face value. Sometimes, a cumulative dividend is not paid out or is reduced in a given year. When dividend payments are reinstated, the company has to catch up on its cumulative dividend duties before it can pay out any dividends on common shares.
Cumulative shareholders will receive both current year and unpaid past dividends before anything is paid out to common shareholders. Cumulative dividend payments are made on a first-incurred, first-paid basis.
The calculation of accumulated unpaid dividends depends on the term sheet. This term sheet outlines the company's terms of investment. Sometimes the term sheet will state that the cumulative dividends are only paid if the company liquidates (financial hardship or by sale).
Another limitation of cumulative preferred shares is that the right to cumulative dividends will end if the company holds an IPO (Initial Public Offering) on the stock exchange or if the preferred shares change into common shares.
Reasons Not to Consider Using Cumulative Dividends
Obviously, it's a priority for the company to pay out the buildup of unpaid dividends. A new business or venture capital scheme may be happy to postpone paying dividends until sometime in the future. If cash flow is expected to pick up quickly and pay out cumulative dividends easily, this may not be a problem.
If a business is eventually sold to another company, the unpaid dividends will usually have to be paid out before the ordinary shareholders receive anything. If the company's sale value is high, this may not be a problem. But it could be important if the sale price is low.
Either way, any company considering cumulative preferred shares should use conservative estimates and carefully discuss the terms of any such shares.
Reasons to Consider Using Cumulative Dividends
Issuing shares can attract more investment in the company by offering a preferred return on investment. This may be a good option in tough financial situations. For example, when the company needs further funds but can't afford to pay out dividends in the short term.
However, there can be several additional reasons for a company issuing preferred shares, including cumulative preferred shares:
- The company may want to limit shareholder control over its operations. Common shares come with voting rights over management decision-making. But preferred shares can be limited. They usually do not have voting rights. Therefore, preferred shareholders get more dividend rights but less voting rights.
- Issuing cumulative preferred shares help keep a healthy balance between debt and equity on its balance sheet. This debt-to-equity ratio is important in assessing a company's financial stability and attractiveness to investors.
- Cumulative preferred shares may be given because they don't need to be immediately repaid. They can be postponed for subsequent years, unlike debt repayments. In other words, paying cumulative dividends is more flexible than other forms of financing.
How to Calculate Cumulative Dividends
Cumulative dividends are calculated for each share according to the term sheet. You can calculate a company's cumulative dividends by:
- Finding each share's annual dividend payment. This is the share's par or face value multiplied by the share's dividend rate. The par value and the dividend rate are noted in the company's preferred stock prospectus.
- Dividing the annual dividend into four quarterly payments.
- Multiplying the quarterly dividend amount by the number of missed quarterly dividend payments.
- Depending on the term sheet, interest may be added to accumulated dividends for suspending payment.
The result is the cumulative dividend for each share that the company owes to its cumulative preferred shareholders.
Frequently Asked Questions
- What is the difference between cumulative and noncumulative dividends?
With cumulative dividends, if a company decides not to issue dividends in a particular year, the amount owed to shareholders is carried over to subsequent years.
With noncumulative dividends, the company doesn't ever have to pay out dividends for that year.
In the future, the company must catch up on all cumulative dividend payments before paying any dividends to common shareholders.
Accumulated preferred share dividends will also rank for payout ahead of ordinary shareholders if the company is sold or liquidates. With liquidation, cumulative preferred shares still rank below the company's creditors.
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