Companies will finance their activities in a variety of ways.
Their long-term finance will definitely come from the owners themselves, i.e., the equity holders (shareholders) or from loans. These loans may be sourced from banks or, many times, from the public. The company may prefer to borrow from the public rather than the banks as the cost of finance may be lower. So companies issue a security in exchange for cash and the security holder receives an agreed fixed and periodic amount of interest.
One such type of security issued by enterprises is preference shares (or “preferred stock” in the US) and the term “share” or “stock” may be confusing in that it gives the impression it is equity! The confusion increases when the interest paid to Preference Shareholders is called a Preference Dividend!
A preference share is like any other Long Term Liability in that it must be paid back when due and its interest must also be paid on dates agreed. Equity holders get paid dividend only when there are sufficient profits available for distribution. The original capital invested is never paid back (it is in fact illegal to pay it back!) except on liquidation, and even in such an event the Equity holders rank last on the list! Preference shareholders rank before Equity holders but after banks and other Debt holders.
So for example if a company closes down and is liquidated, the first to be paid out of any cash available will be the Tax office, Social Security, Employees, secured creditors, unsecured creditors, Preference Shareholders and finally, and if anything is left, Equity holders, otherwise known as Ordinary Shareholders.
How do we make sense of preference shares when calculating a company’s financial risk? Read more on the financial gearing ratio…
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