Dividend Coverage Ratio: All You Need to Know About!

As the name indicates this ratio is about the dividend cover. Dividend coverage ratio is one of the few important investor ratio indicators. It provides information on a company’s ability to pay dividends to its shareholders. It also indicates the profits generated by a company and the portion of income distributed among the shareholders.

What is Dividend Coverage Ratio?

Dividend coverage ratio can be defined as the company’s ability to cover the dividend payout from the profits after taxes. It assumes the total profits available as distributable to shareholders in dividends. It indicates the number of times a company would be able to pay dividends to the shareholders out of post-tax profits.

Dividend Coverage Ratio Formula

It can be calculated by dividing the after-tax profits or operating cash flows by the dividend amount. The company may have preference shares and ordinary shares.

For Ordinary Shares,

Dividend Coverage Ratio   =  (Profits after Taxes – Preference Dividend) ÷ total Dividends Ordinary

Or for preference shares,

Dividend Coverage Ratio   =   Profits after Taxes ÷ total Dividends Preference Shares

Both the ratios can be calculated on earnings per share (EPS) and Dividend per share (DPS) basis as well.

As the preference share dividends are paid before the ordinary dividends, it’s useful to calculate both ratios to reveal a true picture of dividend cover for both types of stockholders.

Working Example

Tech Blue Co has 5 million ordinary shares of 30c each. The market share price is $4.00 each. The industry dividend yield is 5%. Tech Blue co reported a profit for the year is $1,550,000

EPS     = 1, 550,000/5,000,000 = $ 0.31 per share or 31 cents

Total Dividend = (x)/400 * 100 = 5%

=> x = 400*5%/100 = $ 0.2 or 20 cents

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Dividend Coverage Ratio = EPS / DPS

Dividend Coverage Ratio = 31/20 = 1.55 times

How to Find Earnings Available For Common Stockholders

The earnings available for common equity holders are the net proceeds of the total income less taxes and preference dividends. The operating cash flows of a company are used to pay taxes as an obligation. The preferred shareholders receive dividends in priority is the company has a dividend policy. The net proceeds of net profits after the preference dividend can be used to calculate the dividend ratios for equity stockholders.

Dividend Coverage Ratio = (Profits after Taxes – Preference Dividend) ÷ total Dividends Ordinary

A dividend cover ratio may not reveal the full situation of a company’s dividend paying ability. Profits after taxes still require adjustments for non-cash entries such as depreciation and amortizations. A company showing positive profits may still not be able to pay dividends to its common stockholders due to lack of cash.

Therefore, the company profitability or net proceeds for common stockholders and the dividend paying strength should be evaluated separately.

Why Do We Need To Calculate Dividend Coverage Ratio?

The Dividend coverage ratio provides useful information on the dividend paying ability and choice for the shareholders. It can effectively be calculated for both preference and common stockholders.

It offers the shareholders the insights on a company’s dividend paying strength. A high dividend cover would imply the company has the ability to pay dividends more than one time. That leads to the fact, even if the company may not generate enough profits in the next year, it may still be able to pay dividends.

A higher dividend cover means either the company is generating more profits or EPS or paying fewer dividends to shareholders. Therefore, the analysis cannot be interpreted without complete information on the company dividend payout policy.

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As the dividend cover is calculated as a measure of times indicator, a figure of above 1 would imply the company has generated enough profits to pay out dividends. As with any ratio analysis, it can also be interpreted well with industry comparisons. A consistent and stable dividend cover will be preferred by investors than a one-time high cover ratio.

Historical dividend cover analysis may provide useful information on a company’s dividend paying ability. The company may produce higher profits, but still due to lack of cash may not pay dividends to its shareholders. On the other hand, to meet the shareholders’ expectations the company may also fund the dividends with debt financing.

Dividend Coverage Ratio Vs Payout Ratio

Both the dividend related ratios reveal important information for shareholders. The Payout ratio indicates the amount of profits split between retained earnings and dividends. The dividend cover on the other hand, indicates the ability of the company to maintain or pay the dividend to its shareholders out of profits.

The Payout ratio indicates in percentage terms how much profits a company distributed to its shareholders. It reveals the company management choice between investing and dividend payout. Let’s say a company payout ratio is 40%, it means the company retained 60% of profits for reinvestment in the business.

The dividend cover in times indicates the profits available to be distributed among shareholders. For example, if a company has an EPS of $ 1.00 and a DPS of $0.50, it means the company has the profits twice as much as required for dividend payments.

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It should be noted that preference dividends are paid in priority to the common equity stockholders. If a company has preference shares, the dividends are taken as an obligation. The company may also fund the preference dividends through financing and not just the profits.

Advantages of Using a Dividend Coverage Ratio

Investors may use the dividend coverage ratio in conjunction with other investor ratios. It can offer a good starting point to analyze a company’s dividend paying ability.

  • The calculation is simple and gives a times figure that can be easily understood
  • It provides insights on a company’s profits as well as dividend per share
  • Investors can compare the cover ratio with industry standards or historical company data

Limitations of Using a Dividend Coverage Ratio

The dividend cover ratio analysis offers some limitations too:

  • A profitable company may not have surplus cash to pay dividends
  • Operating profits, therefore, do not depict the cash position of a company that is more important for dividend payout
  • It’s a historical performance measure often calculated on outdated information
  • Investors may need to interpret the high cover ratio as low dividend paying policy of a company

Conclusion

Investors would like a higher dividend cover ratio; a ratio above 1.0 would imply the company has enough profits to pay the dividends announced. The Shareholders should also consider the fact that a company with high profitability may still not be able to pay dividends. A lower dividend cover may be due to lower EPS or profits or a higher DPS.

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