This is a complete guide on how to calculate Preferred Dividend Coverage Ratio with detailed analysis, interpretation, and example. You will learn how to use its formula to evaluate a firm's dividend performance.
Definition - What is Preferred Dividend Coverage Ratio?
The preferred dividend coverage ratio (sometimes referred to as times preferred dividend earned) essentially tells you whether or not a company has made enough profit to pay off its preferred dividends.
So it’s a really important one for shareholders in particular but also gives you a sense of how well the company is doing.
Basically, it’s a way of measuring a company’s ability to pay or the relative burden those preferred dividends would have on the company.
The simple formula for finding the preferred dividend coverage ratio involves dividing the total net income by the required amount of preferred dividend payout.
Preferred Dividend Coverage Ratio = Net Income / Preferred Dividend
An important thing to remember is that the required preferred dividend amount includes any accrued amount from previously unpaid dividends.
Company B has reported a net income of $500,000 for the quarter. The company is required to pay out 7% on all preferred shares.
There are 55,000 preferred shares valued at $16.50 per share. They have so far been paying out preferred dividends steadily and have no outstanding balance.
Using the formula, the equation would be:
This is a strong sign that the company will not only be able to pay out its preferred dividends but also pay dividends to its common shareholders as well.
In general, what you are looking for is a number as far above 1 as possible.
Interpretation & Analysis
Ideally, what you want to see is a high enough preferred dividend coverage ratio that the company has no trouble paying preferred dividends.
In other words, it’s not really enough to show that they are just barely capable of paying out those preferred dividends.
They need to be able to pay those and pay sufficient dividends to the rest of their shareholders.
For common shareholders, a high ratio such as the one in the example above is even more important because it gives them an idea of how likely they are to see any dividends themselves.
The company in the example was able to pay out preferred dividends and still had plenty leftover which means they would be in a stronger position to offer dividends to its common shareholders as well.
Cautions & Further Explanation
There are many different kinds of coverage ratios that help you understand a company’s ability to meet its financial obligations.
Because dividends are not a requirement or a standard across the market, it’s not very accurate to compare a company with a low preferred dividend coverage ratio to a company which doesn’t offer any dividends at all.
Moreover, preferred dividends are cumulative. This means that if a company is unable to pay them in a given quarter, the amount owed will rollover into the next dividend payout.
So, as a preferred shareholder, you don’t need to be overly concerned if the company misses a payout.
Natural fluctuations in cash flow and expenses over the year can influence a company’s decision to payout dividends in a given quarter.
This should not immediately be taken as a cause for concern. You only need to start worrying if they are consistently failing to meet their obligation.