Definition: Cumulative preferred stock is a class of stock that where undeclared dividends are allowed to accumulate until they are paid. In other words, it’s a type of preferred stock that has a right to a specific amount of dividends each year. If the dividends aren’t declared or paid, the stock can accumulate the unpaid dividends for a future date when they are declared.
What Does Cumulative Preferred Stock Mean?
Many corporations have multiple classes of stock. Common stock is the standard class that is made up of the owners who have voting rights and can control the future of the company. Common shares are automatically issued when a company is incorporated.
Preferred stock, on the other hand, is a separate class of stock that does not typically have voting rights. Instead, each preferred shareholder has the right to be paid a dividend before a common stock shareholder. Don’t confuse this with the right to be paid a dividend. Preferred shareholders can’t demand the corporation pay a dividend during the year. The board of directors and the company’s management makes this choice. Preferred shareholders simply have the right to be paid dividends before common shareholders when one is declared. If no dividends are declared, no one gets paid.
That is where cumulative preferred stock comes into play. Cumulative shares have a special right that allows them to accumulate undeclared dividends. You can think of it like a savings account. The cumulative shareholders are guaranteed a certain amount of dividends each year, but this amount isn’t always paid out. Any dividends that aren’t paid out go into the savings account called dividends in arrears and will be paid out in future years before any common shareholders can be paid.
Example
Assume a $4 cumulative preferred stock wasn’t issued dividends for 5 years. The dividends in arrears account (the savings account) would have 5 years worth of dividends in it or $20. The company decides to pay out a $15 dividend in the sixth year. The entire dividend must go to the preferred shareholders because of the past due dividends in arrears. The common shareholders would not get a payment that year because the preferred shareholders must be paid first.
