Cumulative dividends are required dividend payments made by a firm to its preferred shareholders. It’s a dividend, usually on preferred stock, that has got to be paid before the other dividend on any of the issuer’s other securities. Preference shares that don’t carry a cumulative dividend are named as “straight preferred.”
A cumulative dividend must be paid, whereas a regular dividend, also called a non-cumulative dividend, may or might not be shareholders at the company’s discretion. If an organization is unable to distribute dividends to shareholders within the period owed, the dividends owed are carried forward until they’re paid. Additionally, the dividends must be paid before common shareholders receive a dividend.
Cumulative dividend formula:
Cumulative Dividend = Dividend Rate × Per Value
Where:
Dividend Rate is the expected dividend payment expressed as a percentage on an annualized basis.
Par Value is the face value for a share.
Note: The dividend rate and par value can be found on a preferred stock prospectus.
Preferred shares are a hybrid between equity and debt. While the assorted rights related to the shares vary greatly from company to company, including voting rights, dividend rate, and order of preference during liquidation, the correct to a cumulative dividend ensures the shareholder of a particular return on investment whether or not the company is profitable.
Preferred shares that have cumulative dividends often have slightly higher rates of return than straight preferred because cumulative preferred carries the added risk of possibly not receiving regularly scheduled dividend payments.
It is important to note that preferred stock is commonly called hybrid security, because of its inherent “equity” and “debt” features.
- Equity feature – Preferred shares are similar to common shares in that they represent an ownership interest and the share price value can appreciate.
- Debt feature – Preferred stock is similar to debt in that a preferred stockholder is paid a fixed dividend periodically (i.e., a cumulative dividend).
Cumulative dividends must be paid by the issuer of preferred shares either at the maturity date or at a later date, if necessary. If a company or an organization cannot pay its cumulative dividend obligation when it’s due, it’s still accountable for paying it within the future possibly with additional interest and it must fulfill this obligation before it can award ordinary dividends to common shareholders.
Cumulative dividends are intended to ensure investors receive at least a minimum return on their investment in the company. Cumulative dividend provisions may contain limitations, such as being payable only if the company liquidates. A company that issues cumulative preferred stock must disclose any accumulated, unpaid dividends in its financial statements.
For example, Company ABC issues some preferred stock with a $1-per-share cumulative quarterly dividend. Company ABC also has some common stock outstanding on which the company paid a $0.50-per-share dividend last quarter.
Now let’s assume a recession has taken a toll on Company ABC’s cash flow, and the board has decided to suspend dividend payments. Because the preferred shares have a cumulative dividend, once Company ABC decides to resume making dividend distributions, it must first “catch up” on any missed dividends payments to the preferred shareholders (those outstanding the longest are paid first). Then it can resume making dividend payments to the holders of its common stock. It must do this even if it does not completely suspend the preferred dividends; reducing them creates a similar obligation.
In a sense, the cumulative dividend is akin to an interest payment on the capital invested by the shareholder to amass the shares, hence the financing element of those shares. However, because they’re shares and not loans to the company, there’s an equity component also.
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