This is an ultimate guide on how to calculate Times Preferred Dividends Earned Ratio with detailed analysis, interpretation, and example. You will learn how to use this ratio formula to evaluate a firm's dividend performance.
Definition - What is Times Preferred Dividends Earned?
Preferred stock is one of the many ways a company can choose to raise capital. It promises a predetermined dividend to be paid on a quarterly or annual basis for perpetuity.
The times preferred dividends earned, also known as the dividend coverage ratio, is a coverage ratio which measures a company’s ability to pay its preferred stock dividend, based on its net income.
Preferred stock holders, as well as common stock holders, use this ratio to gauge the likelihood of a company missing its dividend payments.
The equation for times preferred dividend earned is as follows:
Times Preferred Dividends Earned = Net Income / Preferred Dividend Payout
The equation is simple ratio of a company’s net income to its promised preferred dividend payout.
This allows investors to analyze the likelihood of a company defaulting on its preferred dividend.
An investor may choose not to invest in a company’s preferred shares if the times preferred dividends earned ratio does not exceed one, because that would indicate that a company does not generate enough income to pay dividends.
Okay now let’s consider so you can understand clearly how to calculate this ratio.
Suppose a company has net income of $6 million, and 500,000 preferred stock shares outstanding, with each share paying an annual dividend of $10.
To compute that times preferred dividends earned, you divide $6 million by $5 million (500,000 preferred shares x $10) which equals 1.2.
This means that the company’s net income is 1.2x its preferred dividend.
Interpretation & Analysis
In the example above, the times preferred dividends earned shows that the company has enough net income to afford its preferred dividend payments, signaling to investors that the preferred dividend is secure.
The ratio is also useful for common stock investors, because it can be used to see if there will be any money left over after the preferred dividend is subtracted from the net income.
In the example about, $1 million dollars (16.6% of net income) remains after the preferred dividend is paid off, which give investors a range how much money the next common dividend may be.
Cautions & Further Explanation
When investors use the times preferred dividend earned ratio, they must understand that the company may have other financial obligations that are imperative to the business’ operations that could affect a company’s ability to pay its dividends.
For example, the ratio does not take into account a company’s expected capital expenditures, which may impede the company’s ability to meet its preferred dividend.
Therefore, investors must be wary when utilizing the times preferred dividends earned, and look at a company’s full financial profile before jumping to conclusions.