Noncumulative preferred stock definition
/What is Noncumulative Preferred Stock?
Noncumulative preferred stock allows the issuing company to skip dividends and cancel the company's obligation to eventually pay those dividends. This means that shareholders do not have a claim on any of the dividends that were not paid out. Usually, the issuing company cannot issue dividends to the holders of its common stock in the same year in which it has skipped paying dividends to its noncumulative preferred stockholders, though this depends upon the underlying terms associated with the stock.
Noncumulative preferred stock is extremely rare, because it places the holders of the stock in the uncertain position of not having an assured income stream. Instead, the shares are effectively the same as common stock, where the issuance of dividends is at the prerogative of the board of directors. Theoretically, investors can indirectly influence the issuance of dividends by electing a different set of directors. Understandably, few companies issue this type of shares, since investors are unlikely to buy them, except at a large discount.
The terms associated with noncumulative preferred stock can be altered to improve the value of the stock to investors, such as by only allowing a small number of dividends to be skipped. However, these types of terms can put a business at financial risk, and so must be considered in light of the continuing ability of the company to pay its investors.
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Example of Noncumulative Preferred Stock
For example, ABC Company normally issues a $0.50 quarterly dividend to its preferred shareholders. However, the board of directors feels that there is not sufficient cash flow in the third quarter to pay a dividend. Since the preferred stock is noncumulative, the company has no obligation to ever pay the missing dividend, and the holders of those shares have no claim against the company.
Noncumulative vs. Cumulative Preferred Stock
An issuer of noncumulative preferred stock is under no obligation to eventually pay dividends that it has elected to skip paying. Conversely, an issuer of cumulative preferred stock is obliged to eventually pay these dividends. The usual restriction associated with cumulative preferred stock is that no dividends can be paid on the issuer’s common stock until the cumulative amount of dividends on the preferred stock has been paid. This language is used to protect the dividends of preferred shareholders.
Investors are more willing to purchase cumulative preferred stock, since they have a greater likelihood of being paid dividends. Issuers are more willing to classify preferred stock as cumulative when they are having difficulty raising money; when this is the case, investors can force issuers to include cumulative rights in the stock offering.