This is a detailed guide on how to calculate Dividend Coverage Ratio with thorough analysis, interpretation, and example. You will learn how to use its formula to evaluate a company's dividend performance.
Definition - What is Dividend Coverage Ratio?
The dividend coverage ratio, also known as the dividend cover ratio, is the ratio of a company’s net income over the dividend paid to shareholders.
This ratio tells us the number of times the business can pay dividends to shareholders from the profits it has earned during the period.
The dividend cover ratio is typically used by investors who want to analyze the risk of not receiving dividends.
So typically, a company with a higher ratio would suggest that is capable, potentially several times over, of paying dividends and would therefore be deemed as a less risky investment.
If, on the other hand, the ratio is less than 1, it might imply that the business cannot pay dividends, or is using borrowed money to pay dividends which are not sustainable and would be a cause for concern for investors.
The simple formula to measure the dividend coverage is as follows:
Dividend Coverage Ratio = Annual Net Income / Annual Dividends Paid To Common Shareholders
However, this would then take into account preferred dividend payments which are not available to common shareholders. Instead, we would use the following:
Dividend Coverage Ratio = (Net Income - Dividend Paid On Irredeemable Preference Shares) / Dividend Paid To Ordinary Shareholders
So divide profit after tax less dividends paid on irredeemable preference shares as these payments are not available to common shareholders by dividends paid to ordinary shareholders.
You can find these numbers on a company’s income statement.
Okay now let’s consider a quick example so you can see how easy it is to calculate this ratio.
YBO Company has reported annual earnings of $1,500,000. It must pay $250,000 per year to its preferred shareholders and paid out $470,000 in dividends to its ordinary shareholders in the past year.
To determine the dividend cover ratio, we need to substitute into the formula:
This suggests that YBO Company can pay dividends to its shareholders 2.7 times from the profits it has earned during the period.
Interpretation & Analysis
Typically, a dividend coverage ratio above 2 is seen as being a good measure as it allows for the company to cushion for any uncertainties.
A higher or lower ratio may be adequate depending on the stability within the organization.
A dividend cover that is consistently below 1.5 would be a cause for concern as it would suggest to investors that the business may not be able to maintain the level of dividends should anything have an adverse effect on its profitability in the future.
Cautions & Further Explanation
There are some issues with the dividend cover ratio that need to be addressed.
Firstly, we use net income as a basis for the calculation as opposed to actual cash flow.
This means that a company could potentially report high earnings but not actually have any cash available to make the dividend payments.
It also doesn’t act as a tool for predicting the future.
Net income can change dramatically due to unforeseen events and the result is that a company with a ratio that implies low risk, has no guarantee for investors that it will remain that way in the future.