Understanding Cumulative and Non-Cumulative Preference Shares: A Guide for Investors
Preference shares, also known as preferred stock, offer investors a unique advantage over common stock by providing them with a fixed dividend payment. However, within the category of preference shares, there are two distinct types: cumulative and non-cumulative. Understanding the differences between these types is crucial for investors looking to manage their investment risks effectively.
Cumulative Preference Shares
Definition: Cumulative preference shares guarantee that any unpaid dividends will accumulate. Essentially, if the company decides not to pay dividends in a given year, these dividends are carried forward and added to the next year's dividend pool.
Implication: Holding cumulative preference shares provides investors with a higher level of security regarding dividend payments. Despite potential short-term financial difficulties, the company is legally obligated to settle all past omitted dividends before any dividends can be distributed to common shareholders.
Non-Cumulative Preference Shares
Definition: Non-cumulative preference shares have a different structure. Any dividends that are not paid in a given year are not carried forward. In other words, if the company chooses not to pay dividends, the payment is lost indefinitely.
Implication: This type of share is more risky for investors compared to cumulative preference shares. Investors who hold non-cumulative preference shares do not have the right to receive any past omitted dividends. The missed payment is irretrievable, and there is no legal obligation for the company to make up for it in future dividends.
Summary of Key Differences
Cumulative Preference Shares: Unpaid dividends accumulate and must be settled before any dividends can be paid to common shareholders. This security feature makes cumulative preference shares a more stable investment choice for risk-averse investors.
Non-Cumulative Preference Shares: Unpaid dividends do not accumulate, and missed payments are not recoverable. This attribute makes non-cumulative preference shares riskier but potentially more rewarding in terms of dividend payments during years when the company is financially strong.
Factors to Consider When Choosing Between Cumulative and Non-Cumulative Preference Shares
Investors typically choose between these two types of shares based on their risk tolerance and income needs. Investor who are more cautious and prioritize regular income security would prefer cumulative shares. On the other hand, investors seeking high returns with a higher risk tolerance might opt for non-cumulative shares.
Additionally, it's important to note the liquidity aspect. Cumulative preference shares generally have higher liquidity due to the regular payment structure, while non-cumulative preference shares might attract fewer buyers and thus could be less liquid.
Benefits and Drawbacks of Each Type
Cumulative Preference Shares
Benefits: Guaranteed minimum return, higher security, and regular dividend payments.
Drawbacks: Potential for lower dividend payments during financially challenging years, as the company must first settle all prior owed dividends.
Non-Cumulative Preference Shares
Benefits: Potentially higher dividend payments during years of financial strength, as past missed dividends do not accumulate.
Drawbacks: No guarantee of regular dividend payments, higher risk of losing dividend income in any given year.
In Conclusion
Selecting between cumulative and non-cumulative preference shares involves a careful balance of risk and reward. Investors should thoroughly research the financial health of the company and their own investment goals before making a decision. Understanding these differences can help investors make more informed choices, ultimately leading to a more secure and profitable investment portfolio.
Keywords: cumulative preference shares, non-cumulative preference shares, dividend payments