Question

How does cumulative preferred stock differ from non-cumulative preferred stock?

Short answer

The owners must receive all dividends in arrears in cumulative preferred stock before the company pays dividends to the common stockholders.

For non-cumulative preferred stock, the company isn't expected to pay any dividends in arrears.

Step-by-step solution

Introduction to the topic

Preferred shares, also known as preferred stock, are shares of a company's stock that have dividends paid to preferred stockholders before the issuance of dividends on common stock.

Cumulative preferred stock differs from non-cumulative preferred stock

Cumulative demonstrates a class of preferred stock that qualifies an investor for dividends in arrears.

For instance, an organization issues cumulative preferred stock with a par value of $20,000 and an annual payment rate of 5%. A downfall occurs in the economy; the company can only afford to pay half the dividend and owes the cumulative preferred shareholder $500.

The next year, the economy is even worse, and the organization can pay no dividend at all; it then owes the shareholder $1,500.

Noncumulative depicts a type of preferred stock that does not qualify investors to procure any dividends in arrears. From the above example, if the organization fails to pay the dividend of $1,000, it is not expected to pay the arrears in the next year.

It is only required to pay the dividend for that year.