Dividend Coverage Ratio
Dividend coverage ratio measures the adequacy of a company’s current net income with reference to its dividends. It is calculated by dividing net income available for common stock-holders by the dividends paid to the common stock-holders. Dividend coverage ratio is inverse of dividend payout ratio.
Dividends represent distribution of earnings to the company’s owners. There are two types of dividends: (a) preferred dividends, which are interest-like dividends paid to preferred stock-holders and (b) common dividends, which represent the distribution of income available for common stock-holders. Investors are mostly concerned with income available for common-stockholders and common dividends paid.
Dividend coverage ratio tells us the number of times the current dividends can be paid out of current net income. A high dividend coverage ratio means that it is easy for the company to maintain the current dividend level because its current net income is high enough in relation to the dividend expectations it has created. Because common dividends can be paid out of current income or retained earnings, it is important for a company to have enough net income to sustain its dividend payments.
Formula
Dividend coverage ratio can be calculated by dividing net income available to common stock-holders by the number of dividends paid. Following is the formula:
$$ \text{Dividend Coverage Ratio}\\=\frac{\text{Net Income}\ -\ \text{Preferred Dividends}}{\text{Dividends}} $$
Net income available for common stock-holders equals net income minus preferred dividends. These figures are reported on a company’s income statement. Dividend payment amount can be obtained from cash flow statement and/or statement of changes in shareholders equity.
Dividend coverage ratio can also be calculated indirectly as a reciprocal of the dividend payout ratio:
$$ \text{Dividend Coverage Ratio}\\=\frac{\text{1}}{\text{Dividend Coverage Ratio}} $$
Example
Following is the history of net income and dividend payments of your company over the last 3-years. Comment on the dividend safety of your company and your most prominent competitor which has a dividend payout ratio of 60% over the last 2-years.
| Year | 2013 | 2014 |
|---|---|---|
| Net income (USD in million) | 20 | 25 |
| Dividends (USD in million) | 10 | 11 |
Your company issued preferred stock of $50 million at the start of 2014 and it pays dividend of 8%.
Calculation of dividend coverage ratio for 2013 is straight-forward, just divided the net income by dividend payment. It works out to 2 ($20 million divided by $10 million). It means that based on 2013 income level, your company can afford to pay twice the current level of dividends.
Calculation for 2014 must take into the account the distribution to preferred stock-holders. Net income available for common stock-holders is $21 million (=$25 million minus 8% of $50 million).
$$ \text{Dividend Coverage Ratio}\\=\frac{\text{\$25 million}\ -\ \text{\$4 million}}{\text{\$11 million}}\\=\text{1.90} $$
Your dividend coverage ratio over the two-year period has stayed in the range of 1.90-2.00 which is a good ratio.
The dividend coverage ratio of your competitor can be worked out indirectly as reciprocal of dividend payout ratio:
$$ \text{Dividend Coverage Ratio}\\=\frac{\text{1}}{\text{60%}}\\=\text{1.67} $$
Your company has better dividend coverage ratio. However, you should also look at the dividend yield ratio too.
by Obaidullah Jan, ACA, CFA and last modified on