Dividend Cover Ratio

Dividend cover is the quotient that shows the number of times the total net earnings of a company can cover the dividends to be paid to the owners. In other words, how many times can the net earnings be distributed the owners of the company in terms of dividends?

This can be mathematically expressed as;

Wow, this is interesting! You mean this is the inverse of Dividend Payout Ratio? The answer is yes!

Therefore, note that Dividend cover is the reciprocal of dividend payout ratio (DPR)

Example

ABC co ltd reported net profit after dividend to preference shareholders of $900,000. The business further paid out $300,000 in dividends to its ordinary shareholders in that year.

Required

Determine

i). The dividend coverage ratio
ii). Interpret the results
SOLUTION

i)

ii). For every 3 US dollars attributable to the ordinary shareholders, 1 US dollar is dividend
or we can say that the net earnings of the business covers the dividends of the ordinary shareholders/owners three times
 

Importance of Dividend Cover Ratio

1)    Knowing of the level of dividend cover is important to many stakeholders as explained;
2)    Dividend payment default risk level-the investor is in a position to know the level of risk of not being paid dividends by a business. The lower the dividend cover level, the higher the risk and the vice versa is  true.
3)    Evaluation of firm’s share performance-dividend cover that has an increasing trend represents a future growth and this means future prosperity of the business. hence the investor can choose the right company to invest in.
4)    Increased popularity of the business- for a firm with bigger dividend cover ratio, it implies that it is appealing to many market players and this implies that its market share increases.
5)    Increased share price-when a company has a big dividend coverage ratio, it makes the market price of the firm increase for its demand increases.
6)    Increased market value of the business-in case the business is being sold or taken over by another, the dividend cover determines the price of the business for the higher the dividend cover the higher the market value of the business.
 

Advantages of Dividend Cover Ratio

1)    Used as a gauge to assess the ability of a firm to pay dividends to the investors-i.e owners of the business
2)    A gauge to assess the power of a firm to generate earnings from its ordinary business activities
3)    Dividend cover helps the management know the strength the firm has as compared to its competitors
4)    Dividend cover is a Centre of attracting investors which help in marketability of the firm’s shares in the stock exchange market

Disadvantages of Divided Cover Ratio

1)    High dividend cover ratio does not mean actual cash dividend received by the investors. This is because the firm may be making more profits but with no corresponding actual cash inflows which can guarantee availability of cash for dividend payments.
2)    High dividend cover ratio is not good for a growing business for it implies that most of the net earnings are paid to shareholders and little or no profits are retained for expansion purposes
3)    Dividend cover ratio is rendered useless where tax profile is unfriendly to the business. that is, where taxation rate is very high, this reduces the net earnings of the business and the resulting dividend cover ratio will portray that the business cannot pay its shareholders. Which is not the true position.

Dividend Payout Ratio vs Dividend Cover Ratio

How are this two concepts related to one another? The following table portrays the difference