What are Cumulative Preference Shares?

A company can issue equity shares to the general public. However, it is also allowed to issue another type of share to raise capital. These shares are called preference shares by finance experts. They don't have any ownership rights and can't vote.

Preference share are closer to debt, and can be sub-typed. Cumulative preference shares are one of the most common types of preference shares. Here's all you need to know about cumulative preference shares.

What is cumulative preference shares ?

Cumulative preference share have all the benefits and features of ordinary preference shares, such as higher dividend payouts and preference for dividend payments, and preference for equity shares in liquidation.

Cumulative preference shares, in short, are regular preference shares that have one more benefit. These shares also have an added benefit: holders can receive dividends, even if the issuing firm has not paid them in the past.

Companies might sometimes not be able generate profits for a variety of reasons. Companies may not be able to pay dividends or only a portion of their profits if they are experiencing a lack of profits. Cumulative preference shareholders still have the right to receive dividends, unlike equity shareholders.

Here's an example of cumulative preference shares to help you get a better understanding of the concept.

A sample

Let's say, for example, that a company called ABC Ltd. has issued cumulative preference shares with a face value Rs. 100 shares to the public. The company promises to pay 10% dividends on each share of its face value every quarter for a financial year.

The company has been keeping to its promise and paying a dividend in the amount of Rs. For every quarter of a fiscal year, the company has been paying a dividend of Rs. 10 per share. The company suffered a sudden slump in market conditions and couldn't generate sufficient revenue. It was forced to declare bankruptcy. In such a scenario, the company did not pay dividends to its shareholders, including cumulative preference shareholders, for three quarters of a financial years.

Only in the last quarter of the financial year did the company start generating revenue. As such, it has sufficient revenue to pay dividends to its preferred shareholders. Here is where the fun begins. Cumulative preference shares holders are entitled to regular dividends, even past dividends missed. However, the company must first pay all unpaid dividends. The dividend arrears for Rs. 30 per share) before you get to pay the quarterly dividend of Rs. 10 per share

After the company has paid all arrears, the company will pay cumulative preference shareholders the quarter's current dividends provided there is enough profit. Only after paying all dues, the company will pay dividends to equity shareholders.

The Advantages of Cumulative Preference Shares

We've now seen the example of cumulative preference shares. Let's look at the many benefits these shares provide to investors and the issuing company. These shares offer many benefits.

1. Investors are able to receive a higher dividend rate than equity shareholders.

2. Equity shares have preference over cumulative preference shares in terms of dividend payouts and claims during liquidation.

3. If the company fails to pay the dividends, the cumulative preference shares won't be affected. Unpaid dividends accumulate until the company decides to pay them.

Conclusion

Companies can use cumulative preference shares to raise funds for their operations. These shares not only give companies flexibility but also don't reduce or dilute ownership. Here's a tip: Because the dividend rate for cumulative preference share is lower than regular preference shares, it's usually slightly lower than regular preference shares. This is because unpaid dividends are accumulated rather that lagging.