Companies are generally authorized to issue two different types of shares to the public – equity shares and preference shares. While equity is the most common and the easiest way for a company to raise funds for its business, preference shares can also come in quite handy. Unlike equity, preference shares don’t dilute the control of a company since the holders of such shares don’t get to enjoy any voting rights.
Here’s something that you should know. There are several different categories of preference shares that a company can issue. One among them is non-cumulative preference shares. If you’re wondering ‘what is a non-cumulative preference share?’ right now, then keep reading to find out the real meaning of non-cumulative preference shares.
What is a non-cumulative preference share?
Also simply referred to as preference shares, non-cumulative preference shares are quite different from the other categories of shares issued by a company. Unlike equity shares, the holders of these shares receive a fixed rate of dividend and they get to enjoy a higher preference when it comes to payment of dividends and during the liquidation of the company.
However, if the issuing company misses out or fails to pay the promised dividends, then the holders of non-cumulative preference shares effectively forfeit their claim on these unpaid dividends. This effectively means that the non-cumulative preference shareholders are not entitled to receive any dividend arrears for the past unpaid years, and that if a dividend payout is omitted, it would continue to stay that way.
For instance, if a company is unable to generate revenue for a particular period of time due to any number of issues, it might not pay any dividends for that said period of time. In the event of such a situation, holders of non-cumulative preference shares have no right to receive the dividends and would have to contend with no payouts till the next dividend date.
Let’s now take up an example to better understand the meaning of non-cumulative preference shares.
Non-cumulative preference shares – an example
Assume that there’s a company named XYZ Ltd. that has issued non-cumulative preference shares to the public. The face value of these shares are Rs. 1,000 per share. The issuing company sets the fixed dividend rate at 10% of the face value of the preference shares. The dividend comes up to Rs. 100 per share (Rs. 1,000 x 10%). The company also promises to pay the dividend annually.
For the first two years, the company generated enough profits to distribute the promised dividend amounts of Rs. 100 per share. In the third year however, due to declining sales and an adverse market scenario, the company had to go into a loss as a result of not being able to generate enough revenue. And so, the company couldn’t afford to pay the promised dividend of Rs. 100 per share in the third year.
But then, in the fourth year, the company bounced back up and started generating profits once again. And as such, paid the dividend of Rs. 100 per share for the fourth year. Here, the holders of non-cumulative preference shares cannot force the company to pay the dividends that were missed out in the third year.
Even if the company has profits left over after distributing the dividends to all of its shareholders, non-cumulative preference shareholders cannot raise a claim for the unpaid dividend in the previous year.
Advantages of non-cumulative preference shares
Now that you know the meaning of non-cumulative preference shares, let’s take a quick look at some of the advantages that these shares offer to both the investors as well as the issuing company.
1. Investors of non-cumulative preference shares get to enjoy a much higher rate of dividend when compared with equity shareholders and other categories of preference shares.
2. With respect to the payment of dividends and any other claims during the liquidation process of the issuing company, non-cumulative preference shareholders get preference over equity shares.
Here’s something that you should note. While non-cumulative preference shares are much better than equity shares from an investor’s point of view, it still suffers from one major disadvantage. The unpaid dividends, if any, cannot be claimed at a future point, which is the case with cumulative preference shares. That said, the rate of dividend offered by non-cumulative preference shares is one of the highest among all the categories of shares.