Cumulative Preference Shares: Meaning & Difference

Cumulative preference shares are a type of regular preference share with additional benefits to receive dividends even if the issuing company misses out on paying them. These shareholders are entitled to higher dividend payouts, preference in payment of dividends, and preference in payment over equity shares during the liquidation of the company.

Let us understand more about cumulative preference shares, types, their importance, and more in detail. Read on!

Types of Cumulative Preference Shares

Cumulative preference shares can be further classified into different types based on their unique features and benefits. Below are some of the common types of cumulative preference shares:

• Convertible Cumulative Preference Shares:
  Under certain conditions or after a predetermined period, convertible cumulative preference shares can be converted into a specified number of equity shares.

• Non-Convertible Cumulative Preference Shares:
  Non-convertible cumulative preference shares cannot be converted into equity shares. However, these investors get benefits at the time of dividend payouts and liquidation. These shares cannot be converted into equity shares.

• Redeemable Cumulative Preference Shares:
  After a certain period, redeemable cumulative preference shares can be redeemed (bought back). Companies use this type of preference share to manage their capital structure.

• Irredeemable Cumulative Preference Shares:
  Irredeemable cumulative preference shares do not have a maturity date. These shares remain outstanding indefinitely unless the company decides to repurchase them.

• Participating Cumulative Preference Shares:
  Participating cumulative preference shareholders receive additional dividends along with regular dividends if the company achieves certain financial goals or profits cross a specified threshold.

• Non-Participating Cumulative Preference Shares:
  Non-participating cumulative preference shareholders only receive a fixed dividend and are not entitled to any additional dividends.

How Do Cumulative Preference Shares Work?

Let’s understand the concept with the help of an example:

ABC Ltd. issues cumulative preference shares worth ₹5,000 each, promising an 8% annual dividend.

• First year: The company performs well financially and pays the full dividend. So, the cumulative preference shareholder receives ₹400 (8% of ₹5,000).

• Second year: The company experiences financial stress and is only able to pay ₹200 as a dividend.

• Third year: Due to further downturn, the company does not pay any dividends at all. The total amount now owed to the shareholder is ₹600 (₹200 from the second year + ₹400 for the third year).

• Fourth year: The company recovers and resumes full dividend payments. It must now pay the cumulative preference shareholder ₹600 in arrears + ₹400 for the current year, totaling ₹1,000.

After making payments to cumulative preference shareholders, the company can pay dividends to other shareholders.

Importance of Cumulative Preference Shares

Below are a few of the important aspects of cumulative preference shares:

• Guaranteed Dividend: The unpaid dividend gets accumulated and is paid in the future, even if the company misses out on a dividend payment.

• Priority Over Common Shareholders: Cumulative preference shareholders get priority over equity shareholders. The dividends get paid before equity shareholders.

• Lower Risk Investment: It is an attractive investment option as these shares offer more security and consistent returns.

• Predictable Income Stream: Over time, investors benefit from a fixed and predictable dividend payout.

• Better Protection: Cumulative shareholders have preference over others. Even in low-profit years, these shareholders have a claim on missed dividends before any equity payouts.

Advantages of Cumulative Preference Shares

Here are some of the advantages of cumulative preference shares:

• Higher Rate of Dividend: As compared to equity shareholders, investors enjoy a higher rate of dividend.

• Preference Over Equity Shareholders: At the time of liquidation, cumulative preference shareholders get preference over equity shares with respect to dividend payouts.

• Guaranteed Dividend: In case the company fails to pay a dividend to the cumulative preference shareholder, the unpaid dividend keeps accumulating until the company pays it out.

Disadvantages of Cumulative Preference Shares

Along with several advantages, cumulative preference shares offer a few drawbacks, such as:

• No Voting Rights: Cumulative preference shareholders do not have voting rights. These shareholders have limited influence on any company's decisions or governance.

• Fixed Dividend Rate: The shareholders get lower returns as compared to equity shareholders during high profit periods. They only get a dividend at a fixed rate, which doesn’t increase with the company’s profitability.

• Dividend Payment Obligation: Companies may face difficulty due to accumulating unpaid dividends, which can strain the company’s finances.

• Potential Dilution: Convertible cumulative preference shares into equity can dilute the ownership of existing equity shareholders.

Difference Between Cumulative and Non-Cumulative Preference Shares

Who Should Invest in Cumulative Preference Shares?

If you fall under the categories below, you must invest in cumulative preference shares:

• Conservative Investors: If you prefer low risk and are looking for a steady and predictable income.

• Retired Individuals or Pensioners: If you are looking for consistent returns to manage your regular expenses.

• Investors Focused on Income Rather Than Capital Growth: It is the perfect choice for those who prioritise dividend income over stock price appreciation.

• Long-Term Investors with a Lower Risk Appetite: It is ideal for investors who are looking for long-term investments with assured dividends.
   
• Investors Looking for Priority in Dividend Payments: Cumulative preference shareholders get dividends before common shareholders.

Conclusion

Cumulative preference shares are one of the unique financial instruments that offer stable income with the potential benefits of equity. Investors get predictable returns and a safety net through accumulated dividends with priority in payment over common shares. You can add cumulative preference shares as part of your diversified investment portfolio. Check out our BlinkX App with zero brokerage fees and diversify your investment.