Dividend Coverage Ratio

What is the Dividend Coverage Ratio?

The dividend coverage ratio (DCR) is a financial measure used to determine the number of times the company can pay dividends to shareholders. It is commonly known as the dividend cover, which considers a company's earnings over the number of rewards.  

DCR represents the ability of a corporation to distribute profits to its shareholders. It indicates the number of dividend payments a business may generate from its net income. The greater the cover, the less likely the dividend will decrease during the following year.

Investors and analysts highly use this financial metric to gain knowledge of a company's financial capacity to pay out dividends in the long or short term. Generally, the ultimate goal of utilizing this measure is to analyze the risk rate of not receiving tips.

Understanding the Dividend Coverage Ratio

The Dividend Coverage Ratio assesses a company's ability to pay dividends from its earnings, indicating if it has sufficient earnings to cover dividends.

Investors and financial analysts who use this metric could have different scenarios that are as follows:

• DCR = 1: It indicates that the corporation has paid shareholders all of its annual earnings as dividends. In other words, the company's earnings equal its dividend payments.
• DCR > 1: It implies that the dividend-paying corporation has generated surplus earnings. In other words, the company has safe coverage that enables them to pay dividends while safely allowing for reinvestment or the chances of a market downturn.
• DCR < 1: The company has not earned sufficient earnings to cover the dividend payment. This is a difficult situation, as the company is paying out its reserves, which could be reduced if this continues.
• DCR = 2: It indicated that the company could cover dividend payments twice, considered minimum safe coverage.
• DCR > 2: It implies that the company's earnings cover the dividends payments more than twice.

The dividend cover is an important metric as it evaluates the company's ability to pay out dividends in terms of the company's dividend safety.

Using this ratio enables you to get insights into how safe the company's dividend program is, primarily if investors rely on dividend payments as a source of income.

Investors should avoid firms that constantly have a ratio below 1; it means either the company is making losses and still paying dividends or is consistently using reserves to pay dividends, neither of which is very sustainable.

Investors generally prefer companies with dividend coverage that is more than two as it shows that the company earns earnings that cover dividend payments and reinvestment projects.

Companies that continuously reinvest their earnings have better chances of expanding their business operations and gaining more profits.

Dividend Coverage Ratio Formula

Dividend coverage determines the number of times a company can pay its shareholders' dividends. This metric can be calculated by dividing net income by ordinary dividends or earnings per share by dividend per share.

DCR = Net income / Dividends

  OR

DCR = Earnings per share / Dividends per share

The previous formula cannot calculate dividend coverage for a company that pays preferred dividend payments as it needs modified versions of the coverage ratio.

Investors who are interested in calculating dividend cover for companies that pay preferred dividends must use the following formula:

Dividends Coverage Ratio = (Net Income - Required preferred dividend payments) /Dividends declared

The following formula shows the number of times that the company pays preferred dividends.

 DCR = Net income / Dividends declared to preferred shareholders

Understanding each metric in previous formulas is key to getting an accurate result. The key metrics are as follows:

Net income

A company's net income is the amount remaining after all expenses have been deducted. It differs significantly from gross income, which removes the cost of products sold from revenues.

Net income is a measure of company profitability as it enables investors to determine whether a company earns more than it spends or vice versa. Net income can be calculated by considering several vital indicators investors must understand, such as COGS, interest, and tax.

The net income formula is

Net Income = Revenue - Cost of Goods Sold - Interest - Tax - Operating and other expenses

Dividends

DPS is the total amount of dividends paid per share of common stock for a specified period. The premium per share metric is the simplest way for an investor to calculate how much money they will make from owning shares of a stock over time.

The formula is:

DPS = (Dividends - Annual Dividend Amount) / Shares Outstanding

Preferred dividend payments

Preferred dividend payments are the dividends allocated to pay preferred shareholders before issuing ordinary stock dividends.

If a corporation cannot pay all of its preferred dividends, claims to dividends paid on preferred shares are given priority over claims to dividends paid on common stock.

Earnings per share (EPS)

Earnings per share (EPS) is a financial metric used to price a company and indicate its profitability. They are calculated by dividing the company's profits by its outstanding shares.

Earnings per share = (Net Income - Preferred Dividends) / Common Shares Outstanding

As shown in the formula, preferred dividends must be subtracted from the company's net income, as preferred shareholders have the right to receive rewards within a specific period.

Example of the Dividend Coverage Ratio

Company LYC pays $60,000 in dividends and has a profit after taxes of $90,000. What is the company's dividend coverage ratio?

DCR = Net Income / Dividends

DCR = $90,000 / $60,000 = 1.5

In this case, the company coverage ratio is 1.5 times, which implies that the company has made more money than it needs to pay the dividend.

Hence, they do not have lousy coverage as it enables them to pay a portion of their earnings and use the remaining payments on other operating costs to expand their business.

However, the dividend payment security is low, so the risk of missing payments is high. LYC and TYL company report the provided numbers in the following table:

Calculate the following:

• Dividend coverage for both companies.  
• The portion of the company's earnings that pay as dividends.

LYC

DCR = Net income / dividends

= $130,000,000 / $110,000,000

= 1.2 times

The portion of the LYC's earnings that pay as dividends are:

Dividends % out of company’s earnings

= ($110,000,000 / $130,000,000) * 100

= 0. 846 * 100

= 84.62%

LYC company has made more money than it needs to pay the dividend as its coverage is 1.2 times. However, the dividend security is still low while the risk is high as the coverage <2.

The company pays 84.62% of its earnings as dividends to shareholders, which means they retain only 15% in the company to reinvest in new projects.

TYL

DCR = Net Income / Dividends

= $230,000,000 / $50,000,000

= 4.6 times

The portion of the TYL's earnings that pay as dividends are:

Dividends % out of company’s earnings = ($50,000,000 / $230,000,000) * 100

= 0. 217* 100

= 21.74%

The LYC company has made more money than it needs to pay the dividend, as its dividend coverage is 4.6 times. Therefore, the dividend security is high while the risk is low, as the dividend's coverage ratio is >2.

However, the company pays only 21.74% of its earnings as dividends to shareholders, which means they retain 78.26% in the company to reinvest in future projects. Therefore, TYL has a better chance to grow its business.

BYK and KBF company report the provided numbers in the following table:

BYK

DCR = Net income / dividends

= ($160,000,000 - $8,000,000 - $28,000,0000) / $83,000,000

= $124,000,000 / $83,000,000 = 1.49 times

KBF

DCR = Net income / dividends

= ($290,000,000 - $13,000,000 - $53,000,000) / $53,000,000

= $224,000,000 / $53,000,000 = 4.23 times

Advantages of Dividend Coverage Ratio

Investors usually prefer companies with high dividend coverage, which shows the company's ability to cover and sustain its dividend payments. However, a high ratio has some drawbacks for both investors and the company itself.

Some advantages of high dividend cover:

1. Show company strength

High coverage shows the company has regular and sustained dividend payments. In other words, the company is financially stable and can cover more than two times dividend payments.

Companies with high coverage usually have optimistic expectations for growth in future earnings.

2. Keep shareholders' loyalty

High coverage attracts more investors, showing a low risk of missing dividend payments with high dividend security. Investors relying on dividend payments as a source of income are more likely to keep their shares and reinvest with a high-coverage company.

3. Company growth

The high cover implies that the company retains a large portion of its earnings to fund future operations. Reinvesting earnings in new operations is key to business growth, increasing future earnings and dividend payments.

4. Increase stock prices

A high coverage could imply that the company's stock price would increase as the company's stock demands increase by investors interested in dividend payments rather than capital appreciation.

Increasing a company's stock prices results in increasing its earnings. Expanding the company's earnings shows high dividend payment security and a high possibility of expanding business operations.

5. Build a record of attractive share payout

People who want to make money from stocks are likely to choose companies with a history of giving sustainable dividends. This is especially true for retirees, who often depend on regular payments for their lifestyle.

Issues with the Dividend Coverage Ratio

Some issues of a high dividend coverage ratio are as follows:

1. No guarantee

There is no guarantee that a business will consistently distribute a portion of its earnings as dividends.

Companies that make regular DPS payments may cancel their dividend payments if they are considering an acquisition or making another investment that would cost them a large amount of money.

2. Low capital appreciation

A company that chooses to reinvest its profits rather than distributes them as dividends increase its long-term value, and in turn, the market value of its stock goes up.

However, using a portion of company earnings as dividends decreases the chances of capital appreciation.

Conclusion

The dividend coverage ratio, or DCR, is an important financial indicator that analysts and investors use to evaluate a company's capacity to pay dividends in relation to its earnings.

Stronger dividend security and financial stability are indicated by a larger DCR, whilst possible dividend payment risks are indicated by a lower ratio.

Companies having a DCR of more than two are usually preferred by investors because they indicate strong earnings that can support both dividend payments and future growth.

High dividend coverage also has the potential to raise stock prices, strengthen shareholder loyalty, and facilitate corporate growth through reinvestment. However, regular dividend payments are not guaranteed, and large dividend payments may prevent capital gains.

All things considered, investors looking for steady income streams and long-term investment growth must comprehend and analyze the DCR.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Dividend
• Earnings Per Share (EPS)
• Interest Income
• Liquidity Ratio
• Quick Ratio