Dividend coverage ratio essentially calculates the capacity of the firm to pay a dividend. Generally, this ratio is calculated specifically for preference equity shareholders. Preference shareholders have the right to receive dividends. The dividends of preference shares may be postponed but payment is compulsory and therefore they are considered as a fixed liability.
Dividend coverage ratio is a ratio between earnings and dividend where earnings being the numerator and dividend amount is the denominator. The ratio is relevant for capital providers but especially important for preference shareholders. These shareholders have a preferred right to receive dividends over normal equity shareholders. The dividend payout to equity shareholders is at the discretion of the management but in the case of preference shareholders, the dividend payout is compulsory. The payout of dividend can be postponed but cannot be avoided.
How to Calculate Dividend Coverage Ratio (DCR)?
The computation of DCR is very simple. We just need two elements to compute the ratio viz. net earnings and dividends.
The formula used to calculate the DCR is as follows:
|Dividend Coverage Ratio (DCR)||=||————–|
Net earnings mean the earnings left after all the expenses including the taxes. Why are net earnings used in the calculation of dividend coverage ratio? It is because the dividend is paid out of profits left out to the shareholders. Though preference dividend is a fixed liability, it is not charged to profits of the firm and considered as the appropriation of profits. To add to it, there is no point taking profit before taxes because there is no tax shield available for this fixed liability. Out of the different types of shareholders, the preference shareholders get the preference over others and therefore get paid before any other equity holder receives the dividend.
The dividend here is the amount of dividend-entitled to be received by preference shareholders.
Difference between Dividend Coverage Ratio and Dividend Payout Ratio (DCR vs. DPR)
Let us not confuse between the dividend payout ratio and dividend coverage ratio. The dividend payout ratio is the ratio of earnings which is distributed to equity shareholders. It is simply a ratio between total dividends declared by management divided by total available earnings for the equity shareholders.
Interpretation of Dividend Coverage Ratio
The formula of DCR provides an absolute value rather than a percentage. Ideally, if the ratio comes out to be greater than 1, it means that the earnings are sufficient enough to serve preference shareholders with their dividend. To evaluate the business or firm’s ability to serve, the ratio should be as higher as possible. Keeping a cushion for uncertainties, the ratio above 2 can be considered good.
From the viewpoint of preference shareholders, on the lower side, the ratio of 1 may be sufficient but with a ratio of just 1, equity shareholders have no chance to receive any dividend. So for equity shareholders to expect a dividend, the ratio has to be much higher than 1.