What are Cumulative and Non-cumulative Preference Shares?

This article explores the cumulative and non-cumulative preference shares meaning, their differences, examples, investor suitability, and respective advantages and disadvantages — within the framework of the Indian financial landscape.

Companies issue preference shares as a means of raising capital while providing investors with certain privileges unavailable to ordinary shareholders. Foremost among these privileges is the right to a fixed dividend, distributed before any payment to equity shareholders.

However, the handling of unpaid dividends divides preference shares into two key classifications: cumulative and non-cumulative preference shares.

In essence:

• Cumulative preference shares ensure that if a company cannot pay dividends in a particular year, the unpaid amounts accumulate and are carried forward until they are eventually paid.
• Non-cumulative preference shares, by contrast, do not retain unpaid dividends. If a company fails to declare dividends in a given year, that entitlement lapses permanently.

Understanding this distinction enables investors to gauge the stability, risk, and potential income reliability of their investments in preference shares.

What are Cumulative Preference Shares?

Cumulative preference shares are a class of preference shares where unpaid dividends are accumulated until they are settled. When a company cannot declare dividends due to insufficient profits or adverse financial circumstances, those unpaid dividends do not vanish. Instead, they are carried forward and must be cleared before any dividend is distributed to equity shareholders.

In simpler terms, if a company misses dividend payments in any given year, its obligation to cumulative preference shareholders persists. Once the company returns to profitability, it must pay all arrears owed to cumulative preference shareholders before any distribution is made to ordinary shareholders.

Example:
Suppose ABC Ltd. issues cumulative preference shares with a 10% dividend on a face value of ₹100. If the company fails to pay dividends for two consecutive years due to inadequate profits, it still owes ₹30 per share (₹10 × 3 years) when it resumes payments. Only after clearing this liability can the company distribute dividends to equity shareholders.

Illustration of Dividend Accumulation:

This accumulation mechanism provides a sense of security to investors who prioritise stable and assured income over higher but riskier returns.

What are Non-cumulative Preference Shares?

Non-cumulative preference shares represent a type of preference share in which unpaid or missed dividends are not carried forward to subsequent years. If a company is unable to declare dividends in a given year, shareholders simply lose the right to that dividend — even if the company later returns to profitability.

In this case, the shareholder’s right to the dividend applies only for the current financial year. Once the company omits the dividend for that period, the entitlement lapses permanently. This arrangement benefits the issuing company by providing flexibility during financially constrained periods.

Example:
XYZ Ltd. issues non-cumulative preference shares carrying an 8% dividend on a face value of ₹100. If the company records a loss in 2024 and skips the dividend, shareholders cannot claim that dividend later. Even if the company earns profits in 2025, only that year’s dividend of ₹8 will be paid.

Illustration of Dividend Treatment:

Non-cumulative preference shares are therefore advantageous for companies seeking to preserve liquidity during downturns, as they do not create future liabilities for unpaid dividends.

Key differences between Cumulative and Non-cumulative Preference Shares

The difference between cumulative and non-cumulative preference shares lies primarily in how unpaid dividends are treated. The table below outlines the major distinctions between these two types:

Understanding these distinctions is essential for both investors and corporate issuers, as they directly influence investment appeal and balance sheet management.

Types of investors suitable for each Preference Share

Different investors have varying financial objectives and tolerance for risk. The following table helps determine which type of preference share aligns with particular investor profiles:

Thus, the choice between cumulative and non-cumulative preference shares should reflect both the investor’s risk appetite and the issuer’s financial strategy.

Examples of Cumulative and Non-cumulative Preference Shares

Example 1: Cumulative Preference Shares
MNO Ltd. issues 1,000 cumulative preference shares with a face value of ₹100 and a 9% annual dividend. The company missed dividends in 2023 and 2024 due to weak profits. When it reports improved earnings in 2025, it must pay ₹27 per share (₹9 × 3 years) before distributing any dividends to equity shareholders.

Outcome: Investors receive all accumulated dividends, ensuring continuity of income.

Example 2: Non-Cumulative Preference Shares
PQR Ltd. issues non-cumulative preference shares offering a 7% annual dividend on ₹100 face value. The company is unable to pay dividends in 2023 due to losses but resumes payments in 2024. Shareholders receive only ₹7 for 2024; the missed dividend from 2023 is forfeited.

Outcome: The company benefits from liquidity flexibility, but investors lose out on unclaimed dividends.

Dividend obligation comparison:

Advantages and disadvantages of Cumulative and Non-cumulative Preference Shares

Cumulative preference shares

Advantages:

1. Security of earnings: Investors are assured that missed dividends will eventually be paid.
2. Steady income: Ideal for individuals or institutions relying on stable and predictable returns.
3. Priority in payment: Dividends and arrears are paid before any equity shareholder receives returns.

Disadvantages:

1. Higher cost to the issuer: Companies accumulate obligations that must eventually be paid.
2. Slightly lower dividend rates: Because of the reduced investor risk, companies may offer a marginally lower dividend rate compared to non-cumulative shares.

Non-cumulative Preference Shares

Advantages:

1. Corporate flexibility: Companies can skip dividends in unprofitable years without creating future liabilities.
2. Potentially higher dividend rates: To compensate for increased investor risk, such shares often carry higher dividend yields.

Disadvantages:

1. Income uncertainty: Investors permanently lose any unpaid dividends, reducing reliability.
2. Greater risk: The absence of arrear payments introduces income inconsistency, making them less appealing to conservative investors.

Risk vs Return Pattern:

Conclusion

Both cumulative and non-cumulative preference shares are valuable instruments within the sphere of corporate finance and investment. Their primary distinction lies in how unpaid dividends are treated: cumulative preference shares accumulate and guarantee eventual payment, while non-cumulative preference shares relinquish missed dividends, offering issuers greater flexibility.

In the Indian market context, cumulative preference shares appeal strongly to risk-averse investors such as retirees or conservative portfolios that prioritise regular income. Conversely, non-cumulative preference shares tend to attract investors and companies that accept moderate risk in exchange for flexibility and potentially higher yields.A sound understanding of what cumulative preference shares and non-cumulative preference shares mean allows investors to make informed decisions aligned with their financial objectives. It also enables companies to structure dividend policies responsibly, balancing investor expectations with corporate stability.