Arrears of dividends

3 key takeaways

• Arrears of dividends are unpaid dividends on cumulative preferred stock that have built up over time.
• These unpaid dividends must be paid to preferred shareholders before any dividends are distributed to common shareholders.
• The presence of arrears of dividends can indicate financial difficulties or cash flow issues within a company.

What are arrears of dividends?

Arrears of dividends occur when a company has not paid the expected dividends on its cumulative preferred stock. Cumulative preferred stock is a type of preferred stock that requires the company to pay all missed dividend payments to preferred shareholders before any dividends can be paid to common shareholders. These unpaid dividends accumulate over time and are known as arrears.

Importance of arrears of dividends

Arrears of dividends are significant because they indicate that a company has not met its dividend obligations to its preferred shareholders. This can impact the company’s reputation and the confidence of its investors. Additionally, the requirement to pay these arrears before any dividends can be distributed to common shareholders ensures that preferred shareholders are compensated for the risk they bear by investing in the company.

How arrears of dividends work

Cumulative preferred stock: When a company issues cumulative preferred stock, it commits to paying a fixed dividend to these shareholders. If the company cannot pay these dividends in any given period, the unpaid dividends accumulate as arrears.

Priority of payment: Before a company can pay dividends to common shareholders, it must first pay all outstanding arrears of dividends to its preferred shareholders. This prioritization protects the interests of preferred shareholders.

Financial implications: Accumulating arrears of dividends can signal financial distress or cash flow problems within a company. It also creates a financial obligation that the company must address before resuming regular dividend payments.

Examples of arrears of dividends

• Corporate finance: A corporation issues cumulative preferred stock with a fixed annual dividend of $5 per share. Due to financial difficulties, the company misses the dividend payments for two years. As a result, the company accumulates $10 per share in arrears of dividends. Before the company can declare and pay any dividends to common shareholders, it must first pay the $10 per share to its preferred shareholders.
• Investor protection: An investor holding cumulative preferred stock receives dividends regularly. However, in a tough financial year, the company is unable to pay dividends. These missed payments go into arrears, ensuring that the investor will receive the missed payments in the future before any common dividends are paid out.

Real-world application

Consider a real estate investment trust (REIT) that issues cumulative preferred shares with a quarterly dividend of $1 per share. Due to an economic downturn, the REIT is unable to pay dividends for four consecutive quarters. This results in $4 per share in arrears of dividends. Before the REIT can resume paying dividends to common shareholders, it must pay the accumulated $4 per share to its preferred shareholders, ensuring they receive their entitled payments.

Understanding arrears of dividends is crucial for investors and companies alike. For investors, it provides insight into the financial health of the company and their expected returns. For companies, managing arrears of dividends is essential for maintaining investor confidence and fulfilling financial obligations.

Related topics you might want to learn about include preferred stock, dividend policies, and corporate finance. These areas provide further insights into the mechanisms of dividend payments and the financial strategies companies use to manage their obligations to shareholders.