Technicals Stability Returns

Understanding Dividend Coverage Ratio

The Dividend Coverage Ratio (DCR) measures the number of times a company can pay dividends to its shareholders. It is calculated by dividing the net income by dividend paid. Prospective Lenders used this Solvency metric to analyze the strength of the company in making the payments of interest regularly out of net income. Dividend Coverage Ratio is also known as Dividend Cover.

The formula to derive Dividend Coverage Ratio

Dividend Coverage

Net Income - Net Profit or Net Income is measured by sales minus the Cost of goods sold, general and administrative expenses, operating expenses, other expenses, depreciation, interest, and taxes, etc. Net Profit is found in the Income statement of the company.

Dividend Paid - It is a distributed amount of the company's profits to its shareholders. It is found in the company's Cash Flow Statement.

Example of Dividend Coverage Ratio: For the financial year, ACC limited reported a Net Income as Rs. 1430.18 Cr. and the dividend paid as Rs. 262.90 Cr.
The value as per the formula (Net Income / Dividend Paid) is calculated as (1430.18 / 262.90) = 5.44.

Key Highlight
It is calculated as dividing Net Income by Dividend Paid, and it indicates the number of times a company can cover its dividends by net income.

A dividend coverage ratio above one or two is generally considered as good.

The dividend Coverage Ratio helps to analyze the risk level related to receiving a dividend from an investment.

While looking at the Dividend Coverage Ratio, the following points should also take into consideration:
A high dividend coverage ratio above one or two is considered good. It indicates that the company can easily cover its dividend paid by net income. If the company's ratio is three, it shows that a company can pay dividends three times by its net income.

A low dividend coverage ratio below one suggests that the company is insufficient to pay its dividend by net income.

The dividend Coverage Ratio helps to analyze the risk level related to receiving a dividend from an investment.

A company with a high dividend payout ratio may look attractive, but we should look at other scenarios. If the particular company's dividend payout ratio is high, but its dividend coverage ratio is below one. It indicates that the company's net income is insufficient to pay a dividend, but it is paying dividends. Or it could also mean the company is paying dividends by borrowed funds.

The problem with the DCR is that we took net income to calculate it, and net income does not necessarily equate to cash flow, and the company may report high net income but does not have the cash available to pay dividends.

How to use the Dividend Coverage Ratio effectively
Investors should look for a dividend coverage ratio above 1 or 2. It shows the number of times a company's net income can cover the dividends.

Some companies keep a high dividend payout ratio to keep the investors interested, even if they are struggling with their net income. In this scenario, the dividend coverage ratio is useful to understand how many times it covers its dividends.

While analyzing the company, we cannot depend on one particular financial metric hence the metric that goes along with dividend coverage ratio are Dividend Payout Ratio, Interest Coverage Ratio, Debt to Capital Ratio, etc.,

Range Indicator of Dividend Coverage Ratio

Range Indicator Comments
Above 6 Strong Bullish Excessive Earnings to Cover Dividend
3 to 6 Bullish Surplus Earnings to Cover Dividend
2 to 3 Mild Bullish Sufficient Earnings to Cover Dividend
1 to 2 Neutral Adequate Earnings to Cover Dividend
0.5 to 1 Mild Bearish Shortfall in Earnings to Cover Dividend
0 to 0.5 Bearish Insufficient Earnings to Cover Dividend
Below 0 Strong Bearish Unavailability of Earnings to Cover Dividend