Difference between cumulative and non-cumulative preferred stock

Such stocks which possess more legal status than common stocks are known as preferred stocks. As in the name, preferred stockholders are preferred over common stockholders in terms of dividend payments. Unlike common stockholders, dividend payments of preferred stockholders are fixed and are carried forward in the following years, if company does not pay them dividends in a certain year or period.

Definitions and meanings

Cumulative preferred stocks:

If a stockholder buys a preferred stock in such a situation where the relevant company has not issued dividend payments to the previous owner of these stocks, such a preferred stock is known as cumulative preferred stock.

Non-cumulative preferred stocks:

If a stockholder buys a preferred stock on which the relevant company has already paid all the dividend payments to the previous owner of the stock, such a preferred stock is known as non-cumulative preferred stock.

Difference between common and preferred stock

The main difference between cumulative and non-cumulative preferred stock is given below:

1. Basic distinction:

Preferred stockholders get guaranteed dividends whereas common stockholders only get dividends when the business has surplus cash. This is the reason, if at any time a company is facing a difficult cash situation and cannot pay dividends to any of its shareholders, the dividends of preferred stockholders are shifted in the coming years while common stockholders do not get any dividends in those years. This is because the company is legally bound to pay these payments to preferred stockholders whenever company has enough cash. These kinds of preferred stocks are called as cumulative preferred stocks as holders of these stocks will have a claim on all the pending dividend payments.However, if a certain preferred stockholder is already being paid with all the dividend payments that he or she was entitled to, such stocks will be called as non-cumulative preferred stocks.

2. Economic Status:

The cost of cumulative preferred stocks will always be more than non-cumulative preferred stocks. This is because, the holder of cumulative preferred stocks will get the deferred dividend payments from the company in a future time and so the total cost for the cumulative preferred stocks would be the sum of market price of preferred shares and the total amount of dividends that the holder of the stock has yet to receive.So, if a person wants to buy cumulative preferred stocks from its holder, the individual will have to pay the total or cumulative cost of these stocks. However, in case of non-cumulative preferred stocks,as the company would already have cleared all the due dividend payments to its holder, the prospective buyer who wants to acquire these stocks will only have to pay the relevant market price of these non-cumulative preferred stocks or the price mutually agreed between the two parties.

3. Risk Profile:

Apart from the fact that cumulative preferred stocks have more financial value than non-cumulative preferred stocks, the risks attached to cumulative preferred stocks is more than the risks connected to non-cumulative preferred stocks. This is because, although the company is liable to pay the delayed dividend payments to the holders of cumulative preferred stocks, the fact that the company was unable to pay these dividend payments in the first place indicates that the company was facing a cash shortage problem. This problem may have raised due to the inability of the company to manage its working capital effectually which may further extend to going concern issues for the company and ultimately end up in bankruptcy. In this way the chances of payments of dividends and/or the original capital to the cumulative preferred stockholders will decrease or completely diminish. However, the non-cumulative preferred stocks usually stipulate that the business is running effectively and is totally capable to meeting all of its necessary cash commitments. This mitigates the risk of bad debt for the holders of non-cumulative preferred stocks and makes it a safe investment option for investors.

4. Time Value of money:

The more the dividend payments are delayed the more the money loses its value. Therefore, if an investor acquires cumulative preferred shares, he or she will receive the entitled dividend payments in a future time and so will have to face the risks related to inflation, decrease in value of money or currency etc. However, non-cumulative preferred stockholders will not be exposed to any such risks as they will be getting all their payments in present value terms.

Common versus preferred stock – tabular comparison

A tabular comparison of common and preferred stock is given below:

Conclusion – common vs preferred stock

There are many types of preference/preferred shares that a company can issue. These types may depend upon the legal requirements and regulations of the relevant jurisdiction. Investors prefer preferred stocks because these possess the attributes of both shares and debt securities.These shareholders are regarded more than common shareholders but get fixed divided payments which is very similar to interest payments on debt instruments. However, the investment decision of the prospective investors always depends upon their respective risk appetite and the percentage of return they want.