Dividend coverage ratio
/What is the Dividend Coverage Ratio?
The dividend coverage ratio measures the number of times that a company can pay dividends to its shareholders. The concept is used by investors to estimate the risk of not receiving dividends. Thus, if a company has a high proportion of net income to its total annual amount of dividend payments, there is a low risk that the business will not be able to continue making dividend payments of the same amount. Conversely, if the ratio is less than one, the business may be borrowing money in order to make dividend payments, which is not sustainable.
Formulas for the Dividend Coverage Ratio
The formula for the dividend coverage ratio is to divide annual net income by the annual dividend. It can be prudent to adjust the annual net income figure for any one-time events, such as a favorable payout related to a lawsuit, since these events are not indicative of the long-term ability of a business to pay dividends. The calculation is as follows:
Annual net income ÷ Annual total of all dividends paid to common shareholders = Dividend coverage ratio
A variation is to remove from the net income figure the amount of all required preferred dividend payments, since these payments are not really available to common shareholders. This modified version of the formula is:
(Annual net income - Required preferred dividend payments) ÷ Annual total of all dividends paid to common shareholders
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Example of the Dividend Coverage Ratio
A business reports annual earnings of $1,000,000, must pay $100,000 per year to its preferred shareholders, and paid out $300,000 in dividends to its common shareholders in the past year. This results in the following dividend coverage ratio:
($1,000,000 Annual net income - $100,000 Preferred dividends) ÷ $300,000 Annual dividends to common shareholders
= 3:1 Ratio
Problems with the Dividend Coverage Ratio
Though useful as a general indicator of payment risk, there are several issues with the dividend coverage ratio. These concerns are as follows:
Ignores cash flows. The ratio focuses on net income rather than actual cash flow, which may not reflect the company’s real ability to pay dividends. For example, accounting entries like depreciation or amortization can distort net income, making the ratio misleading.
Ignores other obligations. The ratio does not factor in a company’s obligations, such as debt repayments, which can affect its ability to sustain dividends.
Does not include retained earnings. Companies may pay dividends from retained earnings, which the ratio does not consider. Thus, A low ratio might not indicate trouble if a company has substantial reserves.
Susceptible to manipulation. Companies can inflate or smooth earnings through accounting practices, which can alter the ratio.
Has a short-term focus. The ratio might look good for a single period, while ignoring longer-term trends that could significantly alter its results over the long-term. Also, temporary spikes or drops in net income or dividends can skew the ratio and fail to provide a stable view.
By itself, the dividend coverage ratio provides an incomplete picture of a company's financial health and dividend sustainability. For a holistic analysis, it should be complemented with other metrics like free cash flow, payout ratio, and debt ratios.