Cumulative dividends

Definition

Cumulative dividends are a type of dividend that must be paid to preferred shareholders before any dividends can be distributed to common shareholders. If a company fails to pay these dividends in any given period, the unpaid amount accumulates and must be paid in the future before any other dividends are paid out, ensuring that preferred shareholders receive their due returns.

5 Must Know Facts For Your Next Test

1. Cumulative dividends are especially important for preferred shareholders, as they guarantee payment even if the company has financial difficulties in a given period.
2. If a company has multiple years of unpaid cumulative dividends, it must clear all these arrears before issuing any dividends to common shareholders.
3. The accumulation of unpaid cumulative dividends can significantly impact a company's cash flow and dividend policies.
4. Cumulative dividends are often outlined in the company's articles of incorporation or shareholder agreements, ensuring clarity on payment obligations.
5. Investors may prefer cumulative dividend stocks for their security and reliability, making them attractive during economic downturns when dividend payments may be uncertain.

Review Questions

• How do cumulative dividends affect the relationship between preferred and common shareholders?
  • Cumulative dividends create a clear hierarchy in dividend payments where preferred shareholders are prioritized over common shareholders. If a company does not pay cumulative dividends in any given year, those unpaid amounts must be carried forward and settled before any distributions can be made to common stockholders. This structure helps ensure that preferred investors receive their entitled returns, fostering trust and stability among them.
• Discuss the implications of cumulative dividends on a company's financial strategy and decision-making.
  • Cumulative dividends can significantly influence a company's financial strategy as they create an obligation to pay preferred shareholders before any profits can be returned to common stockholders. This obligation may lead companies to prioritize liquidity management and maintain sufficient cash reserves to meet their cumulative dividend commitments. As a result, during economic challenges, companies may face pressure to make difficult decisions about reinvesting in growth or fulfilling their dividend obligations.
• Evaluate the advantages and disadvantages of investing in stocks with cumulative dividends compared to those with non-cumulative dividends.
  • Investing in stocks with cumulative dividends offers advantages such as guaranteed returns for preferred shareholders, which provides added security during market downturns. This makes such investments appealing for risk-averse investors seeking stable income. On the flip side, non-cumulative dividends might offer higher growth potential as companies can reinvest retained earnings without immediate obligations to pay back unpaid dividends. Thus, the choice between the two depends on an investor's risk tolerance, income requirements, and long-term investment goals.

Related terms

Preferred Stock:

A class of stock that provides its holders with preferential treatment regarding dividends and asset distribution compared to common stockholders.

Dividends: Payments made by a corporation to its shareholders, typically as a distribution of profits, which can be issued in cash or additional shares.

Non-Cumulative Dividends: Dividends that do not accumulate if they are not declared in a given year; preferred shareholders forfeit the right to receive those unpaid dividends.