Dividend Coverage Ratio: Complete Guide to Dividend Cover

Calculation Formula & Examples | Definition & Explanation | Top Tips & Mistakes

Emilie N.- FCCA, CB, MBS
Emilie N.- FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from corporates, financial services firms - and fast growing start-ups.

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Contents

Definition: What is Dividend Coverage Ratio?

The Dividend Coverage Ratio is also known as:

  • dividend cover
  • div cover
  • times covered
  • “DCR” abbreviation

Explanation: What Does Dividend Cover Mean?

For example, a company that generated $10B in net profit and allocated $5B for dividends to shareholders has a dividend cover of 2, which indicates that the company:

  1. Paid 50% of its distributable profits as dividends to reward shareholders now; and
  2. Reinvested 50% back into the business to finance earnings growth in the future.

In other words, a dividend coverage ratio of 2 (also expressed as 2.0, 2:1, 2x, 2 times) means that a company has enough earnings to pay out its dividends twice over.

Why? Well, it is more likely that a dividend will remain stable or rise in the future for a company that retains a high proportion of net income after paying its dividends.

As the ratio falls below 1.5, a company is paying out a large proportion of its earnings as dividends. It may become unsustainable for the company to maintain the current high level of dividends, for example due to a downward trend in profitability. Eventually, this could lead to the company reducing or even eliminating its dividends in the future.

Benefits: Why is Dividend Cover Important?

In short, the Dividend Coverage Ratio assesses the long-term sustainability of dividends by measuring dividend security and company profit retention.

1. Level of security: How safe is the dividend?

The proportion of earnings available for distribution to shareholders in the period that is being retained by a company to reinvest into the business, instead of shared with stockholders in the form of a dividend payment.

2. Extent of profit retention: How much profit is shared with shareholders?

The proportion of earnings available for distribution to shareholders in the period that is being retained by a company to reinvest into the business, instead of shared with stockholders in the form of a dividend payment.

Formula: How Is Dividend Cover Calculated?

Dividend Cover can be calculated in two ways by using either Net Income or EPS as the formula numerator:

Dividend Cover Formula #1: Net Income

Dividend Cover is the ratio of a company’s net income divided by the dividend paid to ordinary common stockholders.

Dividend Coverage Ratio (DCR) = Profit ÷ Dividends

Where:

  • Profit

Profit = Net income available to ordinary common shareholders for the period

    • Net income is the earnings after all expenses, tax and preferred dividends (because preferred dividend payments are not available to common shareholders)
      • Deduct any dividends paid on irredeemable preference shares from earnings to arrive at the profit attributable to common shareholders
      • No adjustment is required for dividends on redeemable preference shares that were already deducted from an income statement (interest expense finance cost)
  • Dividends

Dividend = Total interim and final dividend declared to ordinary common shareholders for the period

    • A variation using dividends paid to preferred shareholders can also be used to determine the number of times a company can pay dividends to preferred shareholders (DCR = Profit ÷ Preferred Dividends)

Dividend Cover Formula #2: EPS

Dividend Cover is the ratio of a company's earnings-per-share to the dividend-per-share.

Dividend Coverage Ratio (DCR) = EPS ÷ DPS

Where:

For companies whose profits fluctuate between periods, the EPS/DPS calculation tends to be more suitable than the alternative Profit/Dividend version of formula.

The result of the DCR ratio is typically expressed as:

  • #” (e.g., ten, 10 or 10.0)
  • “# times” (e.g., 10 times)
  • “#:1” (e.g., 10:1)
  • “#x” (e.g., 10x)
  • “#%” (e.g., 10%)

Many corporations pay dividends quarterly or annually when they submit their required earnings reports. In which case, the earnings report will either contain the numbers you need to calculate the dividend cover or even provide you with the ratio already calculated.

Calculation Examples: 5 Dividend Cover Scenarios

Here are 5 examples of how to calculate the dividend coverage ratio:

Dividend Cover Example #1: Profit ÷ Dividends

Let’s suppose that last year Company A had net income distributable to ordinary shareholders of $100 million and decided to declare a total dividend of $80 million, while Company B with net profit of $200 million only paid out $20 million to its common stockholders.

DCR Example #1: Profit ÷ Dividends
Company Financials Company A Company B
Net income $100 million $200 million
Dividend paid on ordinary shares $80 million $20 million
Dividend paid on preference shares Nil Nil
Dividend coverage ratio (DCR) $100M ÷ $80M = 1.25 times (1.25:1) $200M ÷ $20M = 10 times (10:1)
DCR interpretation Company A paid out 80% of its distributable profits as ordinary dividends and retained only 20% in the business to help finance future operations. Company B reinvested as much as 90% of its profits into the business, sharing only 10% of net income with its ordinary shareholders in the form of a dividend.
Level of dividend security Low dividend security = High risk High dividend security = Low risk
Level of profit retention Low profit retention High profit retention

While Company A is more generous to its shareholders, it faces a much higher risk of not being able to keep up with the current dividend payout level in the future.

Moreover, it could also be argued that the probability of profits dropping in the future is also higher for Company A, because it has retained much smaller portion of profit to fuel its future growth.

Dividend Cover Example #2: Interest & Tax

Calculate the dividend coverage ratios for Company A and Company B based on the following information extracted from their financial statements for the year 202X:

DCR Example #2: Interest & Tax
Company Financials Company A Company B
Profit before interest & tax $130 million $260 million
Interest $5 million $10 million
Taxation $25 million $50 million
Dividend paid on ordinary shares $80 million $20 million
Dividend paid on preference shares Nil Nil
Net income $130M - $5M - $25M = $100M $260M - $10M - $50M = $200M
Dividend Coverage Ratio (DCR) $100M ÷ $80M = 1.25 times (= 1.25:1 ratio) $200M ÷ $20M = 10 times (= 10:1 ratio)

DCR Example #3: Redeemable vs. Irredeemable Preference Shares

Calculate the dividend coverage ratios for Company C and Company D based on the following information extracted from their financial statements for the year 202X:

DCR Example #3: Redeemable vs. Irredeemable Preference Shares
Company Financials Company C Company D
Net Profit $120 million $220 million
Dividend paid on ordinary shares $50 million $30 million
Dividend paid on redeemable preference shares $10 million $40 million
Dividend paid on irredeemable preference shares $20 million $10 million
Dividend Coverage Ratio (DCR) ($120M – $20M) ÷ $50M = 2 times (= 2:1 ratio) ($220M - $10M) ÷ $30M = 7 times (= 7:1 ratio)

Note: No adjustment for the dividend paid on redeemable preference shares is needed in calculating DCR because it has already been accounted for in arriving at the net profit figure.

Dividend Cover Example #4: Common vs. Preference Shares

Calculate the dividend coverage ratios for both the common and preferred shareholders of Company E and Company F based on the following information extracted from their financial statements for the year 202X:

DCR Example #4: Common vs. Preference Shares
Company Financials Company E Company F
Net Profit $120 million $230 million
Dividend paid on ordinary shares $50 million $20 million
Dividend paid on preference shares $20 million $10 million
Dividend Coverage Ratio (DCR) for Common Shares ($120M – $20M) ÷ $50M = 2 times (2:1) ($230M - $10M) ÷ $20M = 11 times (11:1)
Dividend Coverage Ratio (DCR) for Preference Shares $120M ÷ $20M = 6 times (= 6:1 ratio) $230M ÷ $10M = 23 times (= 23:1 ratio)

Dividend Cover Example #5: EPS ÷ DPS

Calculate the dividend coverage ratios for Company G and Company H based on the following information extracted from their financial statements for the year 202X:

  • Company G earned $4 per share for the year and paid an annual dividend of $2 per share.
  • In the last quarter, Company H reported net earnings per share of $2.65 and declared a dividend of $0.23 cents.
DCR Example #5: EPS ÷ DPS
Company Financials Company G Company H
Earnings Per Share (EPS) $25 $2.65
Dividend Per Share (DPS) $5 $0.23c
Dividend Coverage Ratio (DCR) $25 ÷ $5 = 5 times (= 5:1 ratio) $2.65 ÷ $0.23 = 11.52 times (= 11.5:1 ratio)
DCR interpretation The DCR ratio of 2:1 means that Company G generated enough earnings in the year to cover the annual dividend 2 times. In the last quarter, Company H had dividend coverage of 11.5 times.

Interpretation: What is a “Good” Dividend Cover Ratio?

There are no hard-and-fast rules as to what constitutes a desirable dividend coverage ratio apart from this general rule of thumb:

In quantitative terms, dividend coverage above 2.0 is considered good, while a ratio below 1.5 may indicate a risk of a potential dividend cut should a company be unable to sustain its current level of dividend due to insufficient profitability.

What is a Good Dividend Coverage Ratio (DCR)?
DCR Good or Bad?
< 1 Bad
= 1 Earnings = Dividend
< 1.5 Warning sing: Danger of a dividend cut
= 2 Safe minimum
> 2 Good
= 3 Very good

The ratio of 2.0 is desirable because it means that the earnings of a company could cover its current dividend payout twice over, implying that it is generating sufficient income to finance the dividends now and going forward.

The higher the ratio, the more protection shareholders have that the dividend will continue to be paid at the present rate or even possibly be increased in the future.

What is a Good Dividend Coverage Ratio (DCR)?: Detailed Explanation
DCR Interpretation
< 1 Dividend cover of less than 1.0 is a warning sign across most industries because it indicates that a company is not earning enough profits to cover the current level of dividend and needs to finance it from other sources.
= 1 With a dividend coverage ratio of 1.0, a company is earning just enough to cover the dividend payments to shareholders.
< 1.5 Once its dividend cover falls below 1.5 then a company may not be able to sustain the present level of dividends in case of a decline in future profits.
= 2 Generally, a dividend cover of 2.0 or more is regarded as a healthy and safe dividend.
> 2 Generally, companies aim to maintain a dividend cover of at least 2 times to provide a reasonable cash return on investment to shareholders, while at the same time keeping an adequate amount of retained earnings to grow the business.
= 3 A dividend cover of 3 signals that a company has sufficient earnings to pay dividends amounting to 3 times of the current dividend payout.

Investors concerned about the safety of the dividend payout typically look for a dividend coverage ratio of 2.0 or higher.

However, in practice you’ll see that some investors also look for a dividend cover cushion well in excess of 3:1, whereas others are perfectly satisfied with investing into stocks with coverage ratio below 1:1. Let’s take a look at why that is the case >>>

Size Matters: Is High Dividend Cover Better?

Generally speaking, it is considered more favourable to have a higher dividend cover that is stable and continuously increasing year-over-year.

However, there are pros and cons associated with both high and low DCR:

High & Growing Dividend Cover

Arguably, the biggest disadvantage of a high dividend cover is that it may deter investors who are looking to maximize their dividend income, because it means that a company is holding back on dividends in the favour of putting the rest of its earnings back into the business.

On the other hand, because a company with a high ratio is likely reinvesting into its future, it should be able to continue paying dividends at a similar level–or even higher–going forward.

Top 3 advantages associated with a high dividend coverage ratio:

1. Sustainable Dividend

High dividend coverage ratio means that a company has plenty of income left over after paying a dividend.

Therefore, the higher the dividend cover, the more likely it is that the current dividend levels can be sustained in the future, especially if profits drop.

2. Business Growth

For many companies, retained earnings are an important source of funds that enables them to run and grow their business.

Therefore, a high dividend cover may indicate that a company is retaining a higher portion of income to meet its financing requirements. Reinvesting profits back into the business may achieve further growth in earnings, which in turn may result in higher dividend payouts in the future.

3. Managing Expectations

Volatile dividend payouts may be perceived unfavorably by investors and send confusing signals to the stock market.

Hence, companies typically strive to maintain a stable level of dividend coverage ratio in line with the market expectations.

This means that the increase in dividends tends to be continuous and gradual, even in highly profitable periods, to avoid sharp spikes and falls and keep the market expectations satisfied.

Low & Declining Dividend Cover

What does it mean when a company has low, declining or even no dividend cover ratio? >>>

Low DCR

A low dividend cover ratio suggests that a company is paying out a large proportion of its earnings as dividends.

Naturally, investors find high dividend payouts attractive. However, they may be wary of a low DCR because it could signal:

  1. Deteriorating profitability
  2. Need to reduce dividend at the first sign of any financial hardship
  3. Inability to raise dividends as much as companies with lower cover ratios
  4. Failure to retain enough cash to reinvest into a company’s future so it can compete effectively in the market over the long-term
  5. Desperate efforts to attract investment

Therefore, a low dividend cover suggests that a company is facing an increased risk of not being able to sustain future dividend payments to shareholders at the current level.

Declining DCR

Falling dividend cover is likely a result of a company maintaining consistent dividends when profits are declining.

Suppose that a company’s dividend cover has decreased significantly from one year to the next. This could mean that it has decided to maintain dividends at previous year’s level to keep shareholders happy, even though it has experienced a sharp fall in profits.

The market could translate this into a higher likelihood that the company may not be able to maintain the same dividend payments in future years, particularly if its earnings fall even further. This could negatively affect the share price.

Hence, any notable fall in the dividend cover ratio is worth investigating to uncover the root cause and ensure that the decline is temporary and the company’s financial position is otherwise healthy.

DCR <1

Dividend coverage ratio below 1:1 means that a company is not able to pay its dividends out of current earnings but has to use alternative sources of finance.

The alternative sources of finance may include:

  • Tap into retained earnings from prior periods
  • Sell tangible or intangible assets
  • Raise additional debt or equity capital

Of course, this approach is not sustainable in the long run and eventually the company would need to reduce the dividend payments or even suspend them completely.

Negative dividend cover ratios are rarely seen in practice, but it would definitely be a sign of financial problems.

Nil DCR (No Dividend)

An important point to note is that it has been increasingly common for companies to not pay any dividends at all and instead reward shareholders through increased market value of shares.

Top 7 Mistakes: Limitations of Dividend Cover

Although a DCR above 2 is generally considered healthy and anything below 1.5 may be a cause for concern, determining what constitutes a desirable ratio is much more complex in practice.

Here the 7 most important issues for you to consider when analysing the dividend cover ratio:

What Influences Dividend Coverage Analysis? Top 7 Considerations:
Factor Consideration for DCR Analysis
Industry benchmarks: Healthy ratios vary widely among industries and so should be benchmarked against sector averages.
Earnings stability: Companies with stable income may afford to have lower ratios than those with cyclical and volatile earnings.
Company size & growth: High-growth start-ups tend to have higher ratios.
Cash flows: Because net income does not equal cash flow, a company can report high earnings and yet have no cash available to make dividend payments. Again, this is common among high-growth businesses.
Future risk: Ratios based on past performance are not the most reliable indicator of future risk. In DCR, the net income can change dramatically year-over-year and so can the appetite of a company to distribute dividends.
Exceptional items: Earnings can be subject to one-offs, positive or negative, which are unlikely to reoccur in the future (e.g., sale, restructuring or impairment of assets).
Capital structure: Companies with strong low-debt and high-cash balance sheets are more capable to keep their dividends going even if they experience a temporary fall in earnings. Also, equity holders are at the bottom of the capital structure “food-chain”, where companies first needs to pay interest on debt before they can pay their shareholders.

All in all, the dividend coverage ratio is a convenient and useful indicator that allows you to quickly check whether the dividend of a company seems sustainable and the associated level of risk.

However, you always need to dig deeper and evaluate the ratio in context and in conjunction with other financial and non-financial indicators.

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Emilie N., FCCA, CB, MBS
Emilie N., FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from large corporates and banks, as well as fast-growing start-ups.

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