The dividend coverage ratio measures the number of times that a company could 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.
The formula for the dividend coverage ratio is to divide annual net income by the annual dividend, which 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
For example, 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
Though useful as a general indicator of payment risk, there are several issues with the ratio, which are as follows:
- Net income does not necessarily equate to cash flow, so a business could report high earnings, and yet have no cash with which to make dividend payments. This is most common in a growing business, where working capital tends to soak up excess cash.
- The net income figure is not guaranteed to continue into the future, so the risk level indicated by the ratio may be incorrect. This is most common when there are low barriers to entry in an industry and product cycles are short, so that new competitors can take away market share within a short period of time.
- The ratio will change if the board of directors alters the amount of the dividends paid to common shareholders.