Dividend coverage ratio shows the number of times the dividend is covered by available profit and is calculated separately for each class of shares.
For preference shares:
and for ordinary (common) shares:
Profit before tax: $480,000
Corporation tax rate: 50%
Dividend to preference shareholders: $15,000
Dividend to ordinary shareholders: $25,000
Calculate dividend coverage ratio for the use of both preference shareholders and ordinary (common) share holders.
For preference shareholders:
Dividend coverage ratio = (480,000 – 240,000)/$15,000
= 16 times
For ordinary (common) shareholders:
Dividend coverage ratio = ($480,000 – $240,000 – $15,000)/$25,000
A high dividend coverage ratio is the indication of the fact that the company will continue to be able to pay similar or higher dividends in future. A low dividend coverage ratio, on the other hand, shows that even a small decrease in company’s profit will result in reduction in the dividend rate – in other words, the dividends may not be safe. Obviously, a high dividend coverage command better price at the stock exchange.