Preferred stock shares represent an investment in the form of shares issued with a promise of a dividend payout. If a company fails to issue the dividends as pledged, this amount due to the investors is referred to as "dividends in arrears" and is recorded on the company's balance sheet. The term "dividends in arrears" is primarily used to denote the unpaid dividends a company owes to its preferred shareholders. When a company has dividends in arrears, it indicates that it couldn't generate enough revenue to cater to its dividend commitments. This article discusses the impacts it can have on both the company and the investor.
Investors are primarily attracted to preferred stocks due to the dividend they offer. These stocks are essentially a cross between shares and bonds. They provide an ownership stake in the company, but are hardly ever bought with the expectation of a price hike or selling them for profit in the near future. Instead, they are mainly regarded as an income investment. These shares are traded on an exchange, much like common stocks, but they are usually held for their income potential.
In terms of payouts, preferred shares mimic bonds; the investors anticipate a monthly or quarterly payment of a predefined amount. These shares attract more conservative investors or constitute the conservative part of a diversified investment portfolio.
The board of directors of a company have the right to suspend dividend payments for common and preferred shares. If payments are halted, they must be recorded as dividends in arrears on the company's balance sheet. This scenario sends a clear message that the company couldn't generate enough profits to meet its dividend commitments, implying that some of its duties, like payments to regular suppliers, might take precedence.
Preferred shareholders are prioritized when it comes to dividend payouts. Even if a company falls short on profits, all dividends due to preferred shareholders have to be paid before any dividends can be issued to the common shareholders. Besides, preferred dividends can be purchased back from the owner (i.e. they are 'callable') by the company and reissued at a lower rate, especially if the interest rates fall.
Compared to common shares, preferred shares have a higher price tag and are less likely to fluctuate in price. Common shareholders have voting rights and can participate in major company decisions. Preferred shareholders, on the other hand, usually don't have voting rights but have a higher claim on company assets if bankruptcy occurs, even though they are low in line for repayments compared to secured and unsecured creditors, tax authorities, and bondholders.
An instance would be if a company with five million ordinary shares and one million preferred shares was able to pay dividends to common shareholders biennially while promising preferred shareholders a $3 dividend per share annually. In the scenario that the company was unable to pay dividends due to operational and financial issues, it might accrue dividends in arrears owed to preferred shareholders which it would have to pay when it becomes financially capable again.
Notably, only cumulative dividends carry the advantage of the accruing unpaid, guaranteed dividends over time whereas non-cumulative dividends do not offer investors any claims on unpaid dividends due to profit reductions. However, non-cumulative dividends are less common. Some companies might restrict their liability by issuing callable shares, giving them the ability to repurchase existing preferred shares and reissue them with a lower dividend rate based on market interest rates.