Dividend Coverage Ratio


Definition

Dividend Coverage Ratio states the number of times an organization is capable of paying dividends to shareholders from the profits earned during an accounting period.


Formula

Dividend cover in respect of ordinary share capital may be calculated as follows:

Dividend Cover Ratio=Profit after tax - Dividend paid on Irredeemable Preference Shares
Dividend paid to Ordinary Shareholders

Explanation

Dividend Coverage Ratio indicates the capacity of an organization to pay dividends out of profit attributable to the share holders. A dividend cover of 3 implies that a company has sufficient earnings to pay dividends amounting to 3 times of the present dividend payout during the period.

When calculating dividend coverage for ordinary share capital, it is necessary to deduct any dividend paid on irredeemable preference shares from the net profit earned during the accounting period in order to arrive at the earnings attributable to ordinary share holders. Dividend on redeemable preference shares is already deducted from the income statement as interest expense (finance cost) and hence no further adjustment is required in its respect in the dividend cover calculation.

Example

Following information relates to the financial statements of ABC PLC for the year ended 31st December 2012:

$m
Net profit220
Dividend paid on ordinary shares50
Dividend paid on redeemable preference shares30
Dividend paid on irredeemable preference shares20

Dividend Cover in respect of ordinary shares may be calculated as follows:

Dividend Cover=220 - 20=4 times
50

As dividend paid on redeemable preference shares would have been already accounted for in arriving at the net profit of ABC PLC, no further adjustment is required in the calculation of earnings attributable to ordinary shareholders.

Interpretation & Analysis

Dividend Coverage is a measure of the ability of an organization to pay dividends. Although dividend payments are usually discretionary, companies normally seek to maintain a reasonable level of dividend payout in line with the market expectations.

Generally, companies would aim to sustain a dividend cover of at least 2 times in order to avail adequate financing through retained earnings while providing a reasonable cash return on shareholder's investment. A higher or lower dividend cover may be appropriate depending on the level of stability in earnings of the organizations.

Dividend cover consistently below 1.5 may suggest that the company might not be able to maintain the present level of dividends in case of adverse variation in profit in the future.

A high dividend cover may suggest that the company is retaining a higher portion of its earnings to meet its financing requirements which may result in higher dividend payouts in the future.

Importance

Investors use dividend cover ratio to gauge the level of risk associated with the receipt of dividends on their investment. A low dividend cover may suggest investors that the company may not be able to sustain the current level of dividends in case of a downward trend in company's profitability in the future which could impact the valuation of shares.