The dividend coverage ratio indicates the number of times that a dividend is covered by available profit. It is calculated separately for each class of shares.

Formula

To calculate the dividend coverage ratio for preference shares, use the following formula:

Dividend Coverage Ratio Formula For Preference Shares

For ordinary (common) shares, apply this formula:

Dividend Coverage Ratio Formula For Ordinary Shares

Example

Consider the following information relating to a company:

  • Profit before tax: $480,000
  • Corporation tax rate: 50%
  • Dividend to preference shareholders: $15,000
  • Dividend to ordinary shareholders: $25,000

Required: Calculate the dividend coverage ratio for preference shareholders and ordinary (common) shareholders.

Solution

For preference shareholders:

Dividend coverage ratio = (480,000 – 240,000)/$15,000

= 16 times

For ordinary (common) shareholders:

Dividend coverage ratio = ($480,000 – $240,000 – $15,000)/$25,000

= 9 times

Interpretation

A high dividend coverage ratio shows that a company has the ability to pay similar or higher dividends in the future.

A low dividend coverage ratio, on the other hand, shows that even a small decrease in the company’s profit will result in a reduction in the dividend rate—in other words, the dividends may not be safe.

Obviously, companies with high dividend coverage ratios typically command better prices if they are listed on a stock exchange.

True is a Certified Educator in Personal Finance (CEPF®), contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.