Dividend Coverage Ratio

The ratio considering company's earnings over the number of rewards.

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.  

Dividend Coverage Ratio Formula

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.

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.

Analysis

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.

DCR 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.

Formula

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 company pays preferred dividends.

 DCR = Net income / Dividends declared to preferred shareholders

Paperwork

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

1. 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.

2. 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

Earnings

3. 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.

4. Earnings per share (EPS)

Earnings per share is a financial metric used to price a company and to indicate the company's profitability. EPS is calculated by dividing the company's profits by the company's 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.

Examples

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

Example

DCR = Net income/ dividends

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

The company coverage ratio, in this case, 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 reports the provided numbers in the following table:

Example
Financial factorLKCTYL
Net income$130,000,000$230,000,000
Dividend payments on ordinary shares$110,000,000$50,000,000

Calculate the following:

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

LKC

DCR = Net income / dividends

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

= 1.2 times

The portion of the LKC'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%

LKC 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%

LKC 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.

Solution

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

Example
Financial factorBYKKBF
Interest$8,000,000$13,000,000
Tax$28,000,000$53,000,000
Profits before interest and tax$160,000,000$290,000,000
Dividend payments on ordinary shares$83,000,000$53,000,000

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 and disadvantages

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

Some advantages of high dividend cover:

  • 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.

  • Keep shareholders' loyalty.

High coverage attracts more investors, showing a low risk of missing dividend payments with high dividends 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.

It allows corporations to share their earnings with their shareholders while retaining the remaining in the business for future operations.

  • Company growth

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

  • 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 result in increasing its earnings. Expanding the company's earnings show high dividend payments security and a high possibility of expanding business operations.

  • 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.

Disadvantages

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

  • 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.

  • 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 decrease the chances of capital appreciation. 

Bar Graph

Key Takeaways

1. The dividend coverage ratio is a financial metric that reflects the number of times the company can pay dividends to shareholders.

2. This financial measure is crucial for investors and analysts as it enables them to understand a company's ability to pay dividends in the long and short term.

3. The ultimate goal of this metric is to assess the risk of not receiving dividends.

4. This metric could have different scenarios:

  • DCR = 1

It indicates that the company's earnings equal its dividend payments.

  • 1< DCR < 2 (Risk of cut dividends)

It indicates that the company has a difficult situation as they could cut the dividends payments if their earnings drop.

  • DCR = 2 (minimum safe coverage)

It indicated that the company could cover dividend payments twice, considered safe coverage.

  • DCR > 2 (good coverage)

It implies that the company's earnings cover the dividends payments more than twice.

5. This metric is calculated by dividing net income by ordinary dividends or earnings per share by dividend per share. 

6. The formula for calculating dividend cover for a company that pays preferred is:

Dividends coverage ratio = (Net income - Required preferred dividend payments) /dividends declared

7. Some advantages of high coverage are as follows:

  • Show company strength because of its sustained dividend payments.
  • Keep shareholders' loyalty as they regularly receive their dividends.
  • Company growth which in turn increases its future earnings and dividend payments.
  • Increase stock prices due to the company's reputation for sustaining dividend payments.
  • Build a record of attractive share payout.

8. Some disadvantages of high coverage are as follows:

  • There is no guarantee that a business will consistently distribute a portion of its earnings as dividends as they could cut their dividend payments.
  • Since many company earnings are used as dividends, low capital appreciation decreases the capital appreciation rate.
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Researched and authored by Khadega Bazarah | LinkedIn

Reviewed and edited by Aditya Salunke I LinkedIn

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