Dividend coverage ratio

Dividend coverage ratio shows the number of times the dividend is covered by available profit and is calculated separately for each class of shares.

Formula

For preference shares:

dividend-coverage-ratio-formula-preference

and for ordinary (common) shares:

dividend-coverage-ratio-formula-ordinary

Example

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.

Solution:

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
9 times

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.

Also Check:  Average stock retention period ratio

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