Dividend Coverage Ratio
This ratio calculates the dividend potential of the company. A company pays its shareholders dividends only when it makes a profit. This statement is applicable to the common stockholders of the company, but what about preference shareholders? The company can put off the distribution of dividends to preferred shareholders but cannot call it off. It is a compulsory payment. Therefore, this ratio is more important for preference shareholders. The dividend coverage ratio calculator calculates how often the dividend can be paid out. In other words, how many times are the earnings of the company with regard to its standard dividend payout pattern?
The formula for calculating the dividend coverage ratio is as follows:
Dividend Coverage Ratio:
For Preference Shareholders = Net Income / Dividend for Preferred Stock
For Equity Shareholders = (Net Income – Dividend for Preferred Stock) / Dividend for common or equity shareholders
How to Calculate using Calculator?
The following three variables are required to be inserted into the dividend coverage ratio calculator to get the dividend coverage ratio for both preferred stocks as well as the common stock quickly.
The net income refers to the earnings of the company left after deducting all the expenses plus taxes. This can also be referred to as earnings after interest and taxes. The net income amount differs for both preferred stockholders and equity shareholders. The income obtained after paying taxes is the net income for preference shareholders, while the earnings left after honoring the preferred dividend is the net income for equity shareholders.
Dividend for Preferred Stock
Enter the figure of dividend allowed for the preference capital of the company.
Dividend for Common Stock
Enter the figure of dividend allowed for equity capital, or we can say, the dividend for common shareholders of the company.
Let us take an example for a better understanding.
Assume a company has $500,000 of 7% preference share capital and $ 500,000 of equity share capital. The rate of dividend for equity shareholders is 10%. The net income of the company is $434,000.
Dividend for preference capital = $35,000 (i.e., 500,000*7%)
And, dividend for equity capital = $50,000 (i.e., 500,000*10%)
Therefore, dividend coverage ratio for:
Preference Capital = 434,000 / 35,000 = 12.4
Equity Capital = (434,000 – 35,000) / 50,000 = 7.98
To interpret this in the simplest way, a ratio above 1 means the company has sufficient net income to distribute dividends. While a ratio less than that means the company will not be able to pay dividends.
In the above example, the dividend coverage ratio for preferred stock is 12.4, which means the company has enough earnings that it can pay the dividend to preference shareholders 12.4 times. And same goes for equity dividends. This ratio should always be > 4 or 5 under normal circumstances because a growing company would not like to distribute all its earnings through dividends. Instead, a major portion will be retained for further investments and growth.