Investor Ratios measure how attractive public limited companies are for current and future shareholders to purchase. Dividend Cover is one of them.
Buying shares in a company has the potential for two kinds of financial return. Capital gains can be made when the share price is rising – you buy when cheap and sell when expensive. In addition, companies pay annual dividends to shareholders – you get a part of the firm’s profit (unless profits are too low or losses are made).
Investor Ratios give an indication of the prospects for financial gain from both of these sources.
What does Dividend Cover measure?
Dividend Cover is ratio between Net Profit After Interest and TAX, and Annual Dividends. It compares Net Profit After Interest and TAX with Annual Dividends.
Dividend Cover measures the number of times the dividend could be paid out of from current earnings after TAX.
The Dividend Cover ratio is the opposite of the Dividend Payout ratio.
Dividend Cover measures how many times the business can pay out the dividend from current earnings after TAX.
How to calculate Dividend Cover?
The figures for working out Dividend Cover can be found in Profit and Loss Account (P&L Account), The EDGAR System, the primary system for companies to file documents for The SEC (The U.S. Securities and Exchange Commission), Yahoo Finance, or any reliable stock broker:
| Net Profit After Interest and TAX | |||
| Dividend Cover = | ━━━━━━━━━━━━━━━━━━━━ | ||
| Annual Dividends |
Example for Dividend Cover
A company with Net Profit After Interest and TAX of USD$4,000,000 that pays USD$2,000,000 in Annual Dividends has Dividend Cover equal 2. Dividend Cover of 2 implies that a company has enough Net Profit After Interest and TAX to pay dividends amounting to 2 times of the present Annual Dividends payout.
Comment
Dividend Cover is expressed in times as a number.
Dividend Cover is a widely used metric to determine whether the company is able to continue paying dividends attributable to the owners from its net earnings. Investors will gauge the level of risk associated with the receipt of dividends on their investment to find out whether the firm can sustain the present level of dividends.
High Dividend Cover means that the more able the company is to pay the proposed dividends, leaving a considerable margin for reinvesting profits back into the business. Perhaps they are retaining a high level of profit to expand the business, from which shareholders could benefit in future.
If directors decided to increase dividends to shareholders, with no increase in profits, then Dividend Cover would fall. Potential investors might start to question whether this level of dividend can be sustained in future.
Low Dividend Cover means that the company has paid out a large portion of its net earnings as dividends. A low result means the directors are retaining low profits for future investment and this could raise doubts about the company’s future expansion. A company that has a low Dividend Cover will struggle to sustain the present level of dividends, if the company’s profits decrease. If a company’s dividend coverage ratio is less than 1, it might be borrowing funds to pay dividends.
How to improve Dividend Cover?
Improved Dividend Cover ratio means higher Dividend Cover. The company can now pay out the dividend more times from current earnings after TAX. The company is more able to continue paying dividends to the owners from its net earnings.
1. Higher Net Profit After Interest and TAX. The company should increase Sales Revenue as well as decrease the cost of production Cost of Goods Sold (COGS), decrease Expenses (Overheads), decrease Interest payments on debt and decrease TAX obligations to the government.
2. Lower Annual Dividends. The company can increase the dividends paid out to shareholders. The directors should decrease the proportion of Retained Profit for future investment. In case increasing annual dividends is not possible, use alternative sources of finance. The alternative sources of finance may include tapping into Retained Profits from past years, selling assets, raising additional debt finance through long-term loans and bonds, and raising equity capital through issuing additional shares.
Investor Ratios are of particular interest to current shareholders and prospective investors who need to assess the rate of financial return on shares and risk when making an investment to buy the shares.
