Dividend Coverage Ratio

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

Dividend

Net Earnings

Net earnings means 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 Coverage Ratiodividend is paid out of profits left out to the shareholders. Though preference dividend is a fixed liability but 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.

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.


Last updated on : August 31st, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Return on Capital Employed (ROCE)
  • How to analyze and maximize Gross Profit Margin
    How to analyze and maximize Gross Profit …
  • Enterprise Value
    Enterprise Value
  • Calculate Debt From Balance Sheet
    How to Calculate Debt from Balance Sheet?
  • How to Analyze and Improve Debtors Turnover Ratio / Collection Period?
    How to Analyze and Improve Debtors Turnover …
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook


    Related pages


    examples of restrictive debt covenantscapital budgeting process stepscalculating turnover ratiohow to calculate asset turnoverliquidity calculation formulaadvantages and disadvantages of gordon growth modelexplain arbitragenoa turnoverpayback method definitionroce formulahedging definition financequick ratio calculationhow to do inventory turnoverrevolving letter of credit examplecash vs accrualshareholder funds formuladebt to total asset ratio formulamanagement of economic exposureprofitability ratios typesdcf model exampledebt financing advantages and disadvantageswhat does irr mean in financewacc and discount rateprofitability index equationreceivable discountinghurdle rate calculatoradvantages and disadvantages of shareholdersnovated lease vs hire purchasedupont financial analysisebit formula in financedefine debt covenantror financewacc computationaccounts receivable collection period formulalong term debt calculatordefine floating rate bondreceivables debtorsdebit the giverirr decision rulestock turn calculation retailvertical merger companies listhow to compute debt ratiowhat is packing creditdiscounted payback calculationmeaning of dividend per sharered clause letter of creditdefinition of arbitrage pricing theoryoverdraft interest rateconstant growth stock calculatortobin q theory of investmentbcr calculator ratefinancial management ratio analysis formulashire purchase liabilitiesvertical merger companiesleasing disadvantagesasset turnover meaningsynonyms of utmostadvantages and disadvantages of economic order quantitysundry creditor definitioncapm vs waccwacc graphdefinition of irrdifference between cash credit and overdraftbook keeping definationbreak even point in unit sales formulaforeign trade advantages and disadvantagessg&a accountingwhat does sweat equity meandivident coverintangible asset meaningsolvency analysis definitionincrementalism definitionwhich accounts normally have debit balanceswhat is bills of ladinghedging policy definitionstock turns calculationhow to calculate average receivables