Updated July 19, 2023
What are Non-Cumulative Preference Shares
The term “non-cumulative preference shares” refers to the variant of preference shares where issuing companies have no obligation to pay any unpaid or omitted dividends to the stockholders.
In other words, if the issuing company cannot pay dividends during a particular period due to unforeseeable financial stress, then the holders of non-cumulative preference shares have no right to claim any of the unpaid dividends in the future.
Explanation
Usually, the board of directors of the issuing company has the flexibility to cut or suspend the dividend payment when the company experiences financial distress. Now, unpaid dividends of non-cumulative stockholders will not become arrears in such a scenario, meaning that the company will not be liable to pay any unpaid dividends to the non-cumulative preference stockholders. Effectively, non-cumulative preference shareholders offer financial flexibility to the companies during times of liquidity stretch.
Features of Non-Cumulative Preference Shares
The features of non-cumulative preference shares are as follows:
- They receive pre-set dividend rates expressed as a percentage of the face value or the share price.
- The issuing companies can resume making the dividend payments at any time without regard to unpaid dividends.
Examples of Non-Cumulative Preference Shares
Following are the examples are given below:
Example #1
Let us use ADF Inc.’s example to illustrate the computation of dividends for non-cumulative preference shares. In 2009, the company issued 10,000 shares of $10 non-cumulative preferred stock and 5,000 shares of $7 cumulative preferred stock. However, due to significant market disruption, the company incurred losses and didn’t pay dividends during the year. The company witnessed a strong recovery the following year, so the board of directors decided to pay a dividend of $200,000. Determine the dividend paid to the cumulative and non-cumulative preferred stockholders during 2009 and 2010 combined.
During 2009, there will be no arrears for the non-cumulative preferred shareholders. However, an arrear of $35,000 (= $7 * 5,000) will be created for the cumulative preferred shareholders.
In 2010, the company will pay dividends worth $100,000 to non-cumulative preferred shareholders (calculated as $10 multiplied by 10,000 shares), and cumulative preferred shareholders will receive dividends worth $70,000 (calculated as $7 multiplied by 5,000 shares for 2010 and $35,000 in arrears from 2009). The common stockholders will receive the remaining $30,000 in dividends, which is calculated by subtracting $100,000 and $70,000 from the total dividend amount of $200,000. Therefore, during these two years, the cumulative and non-cumulative preferred stockholders earned dividends of $70,000 and $100,000, respectively.
Example #2
Let us take the example of the above company again. In this case, the company paid a dividend of $160,000 and $180,000 in 2011 and 2012, respectively. Determine the dividend paid to the combined cumulative and non-cumulative preferred stockholders during 2011 and 2012.
Non-cumulative preferred shareholders will be eligible for a dividend of $100,000 ($10 multiplied by 10,000 shares), whereas cumulative preferred shareholders will be eligible for a dividend of $35,000. The Common Stockholders will receive the remaining $25,000 in dividends (obtained by deducting $100,000 and $35,000 from $160,000).
Again in 2012, the cumulative preferred shareholders will get a dividend payment of $35,000 (= $7 * 5,000), while the non-cumulative preferred stockholders will receive $100,000 (= $10 * 10,000). The cumulative and non-cumulative preferred stockholders consequently received dividends of $70,000 and $200,000, respectively, over the course of these two years.
Cumulative vs Non-Cumulative Preference Shares
Some of the major differences between cumulative and non-cumulative preference shares are as follows:
- In contrast to a non-cumulative preference share, which permanently forfeits its unpaid dividend if a dividend payment is missed within a specific period, a cumulative preference share’s unpaid portion forms part of the arrear and may be paid at a later time when money becomes available.
- Cumulative preference shares receive dividend payments ahead of non-cumulative preference shares.
- Cumulative preference shares offer a lower dividend rate as compared to non-cumulative preference shares.
Advantages
- Since there is no strict obligation to pay dividends for these stocks, its non-payment doesn’t amount to bankruptcy.
- Unlike interest payment on a debt or divided payment on cumulative preference shares, these stocks have no fixed liability. As such, it helps improve the capital structure ratio (e.g., debt-to-equity ratio) and, in the process, enhances the company’s borrowing capacity.
- These shares don’t require a charge on assets and so the issuing companies can raise the required money while their assets continue to remain free of any charge.
Disadvantages
- Non-cumulative preference shares are one of the costliest sources of funds.
- Although the issuing company doesn’t face any legal implications due to the non-payment of dividends, it may dent the investor’s confidence and impact the company’s image.
- Although the risks of non-cumulative shareholders are pretty similar to those of equity shareholders, non-cumulative shareholders have limited payouts, unlike equity shareholders.
Conclusion
So, one of the striking features of non-cumulative preference shares is that there is no liability to pay, which offers flexibility to companies during times of financial crisis. Further, the unpaid dividends also don’t amount to any arrears. As such, companies should include non-cumulative preference shares in their capital structure.
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