What it means
Preferred shares sit between borrowing and ordinary equity, and their dividend is normally fixed as a percentage of a stated par value. When that dividend is cumulative, a payment the board skips is not lost; it is recorded as an arrear and remains owing until the company is able to settle it.
This matters because directors can suspend a dividend in a difficult year without breaching any contract. Cumulative terms mean the preferred holders lose the timing of their cash but not the amount, while ordinary shareholders are locked out of distributions until the backlog is cleared.
In the accounts, arrears are usually disclosed in the notes rather than recognised as a liability, because a dividend only becomes a legal obligation once it is declared. Analysts still treat the balance as a genuine claim and deduct it when working out the earnings truly available to ordinary shareholders.
Ignoring it flatters earnings per share. Terms vary a great deal from one instrument to the next.
Non-cumulative preferreds lose a skipped payment forever, participating preferreds share in upside as well as receiving their fixed entitlement, and venture capital preference shares often accrue at 6% to 10% and roll up quietly until an exit event. Two details are worth checking in any document before signing.
The first is whether arrears themselves compound, since some instruments charge a rate on unpaid amounts; the second is whether arrears settle in cash or convert into extra shares on a sale or listing.
In practice
Real-world examples.
Example
A family-owned packaging company issues $2,000,000 of 8% cumulative preferred shares to a local investor to fund a new production line. Two lean years produce arrears of $160,000 x 2 = $320,000, which the company clears in full before restoring dividends to the founding family.
Example
A software start-up raises a funding round on cumulative preference terms accruing at 8% a year. Four years later at the trade sale the accrued amount is added to the preference and paid before anyone else, which noticeably reduces the founders' share of the proceeds.
Example
A regional hotel group suspends its preferred dividend during a refurbishment programme and discloses $450,000 of arrears in the notes to its accounts. Its lenders take comfort from the fact that the arrears do not trigger default, while the preferred investors take comfort from knowing the amount has not been forgiven.
Formula
Calculation
Annual cumulative dividend = Par value x Dividend rate x Number of preferred shares
Arrears = Annual cumulative dividend x Number of years missed
A distribution business has issued 10,000 preferred shares with a par value of $100 each and a cumulative dividend rate of 6%. The annual entitlement is $100 x 6% x 10,000 = $60,000. Trading is poor in years one and two and the board skips both payments, so arrears build to $60,000 x 2 = $120,000. Year three is much better and the directors want to pay ordinary shareholders, but they must first settle the $120,000 backlog plus the current year's $60,000, a total of $120,000 + $60,000 = $180,000. Only after that $180,000 has been paid can any cash flow to ordinary holders.Case study
Seen in the real world.
Harbour Line Foods is an illustrative and completely fictional regional food producer created to show cumulative dividends in action. To fund a new chilled warehouse it issued 20,000 preferred shares of $50 par carrying a 7% cumulative dividend, an annual commitment of 20,000 x $50 x 7% = $70,000.
A poor harvest and a lost supermarket listing meant the board skipped the payment for three consecutive years, building arrears of $70,000 x 3 = $210,000. The founders were frustrated, because their own ordinary dividends were blocked for the whole period even though the business had returned to profit in year two.
When a new contract restored cash flow in year four, the company paid the $210,000 of arrears plus the year four entitlement of $70,000, a total of $280,000, and only then resumed ordinary dividends. The episode is a reminder that cumulative terms are cheap to agree and expensive to forget.
Watch out
Common mistakes.
- Assuming a skipped preferred dividend has been waived, when cumulative terms mean it is merely deferred.
- Recording arrears as a liability on the balance sheet before the dividend has actually been declared.
- Calculating earnings per share for ordinary shareholders without deducting the cumulative preferred entitlement for the year.
Questions
People also ask.
Do cumulative dividends earn interest on the arrears?
Only if the terms say so, and many do not, which is why the document has to be read rather than assumed.
Can a company be forced to pay the arrears?
Not directly, but it cannot pay ordinary dividends until the backlog is settled, and the arrears usually rank ahead on a sale or winding up.
Are cumulative preferred shares debt or equity?
Legally they are equity, though the fixed accruing entitlement makes lenders and analysts treat them as something close to debt.
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