In simple terms, the Dividend Coverage Ratio (DCR) calculates how many times a company can pay dividends to its shareholders using net income. This is also commonly known as dividend cover and enables investors to estimate their risk of not receiving dividends. DCR is also valuable for companies to assess the current and future sustainability of the dividends they payout.
If a company has a high DCR, this usually signals that they are able to maintain their current dividend payments. In addition, a high DCR indicates that a company is holding back a sufficient portion of income after all necessary deductions are made. Reinvesting these profits back into the business can lead to a further increase in cash flow, thus leading to higher dividend payouts in the future.
However, a low DCR might indicate that a company is borrowing money in order to pay dividends. It shows that the company may be experiencing a decline in profitability or failing to retain large enough sums to reinvest into the business. Consequently, directors will often aim to achieve and preserve a high DCR.
Although there are some variations, the basic formula used for calculating DCR is as follows:
DCR = net income / dividend declared
In this formula, net income is defined as the overall profit that remains after all expenses and costs have been subtracted from the total revenue. The dividend declared is defined as the number of dividends that are entitled to shareholders.
This formula can be modified to allow investors to calculate how many times a company can pay dividends to shareholders if it also needs to take into account preferred shares. The formula for this second method is:
DCR = (net income - required preferred dividend payments) / dividends declared to common shareholders)
What are some examples of DCR?
Generally speaking, a DCR of 2 is viewed as good, as this indicates that a company has the capacity to pay its dividends twice over. A DCR of below 1.5 is viewed as a possible concern, signalling the use of loans. It is also important to note that some companies may choose not to pay dividends at all and instead increase their market value of shares as a way to thank shareholders.
An example of DCR in action is as follows:
A company reports annual earnings of $1,000,000 and must pay $100,000 annually to its preferred shareholders along with paying out $300,000 in dividends to its common shareholders within the past year. The formula we would use to calculate the DCR for this scenario would be:
(£1,000,000 net income - £100,000 preferred dividend payments) / £300,000 dividends to common shareholders = a DCR of 3:1
Are there any issues with the dividend coverage ratio?
DCR is a useful metric that allows investors to check the sustainability of a company’s dividend payments. Nevertheless, there are some disadvantages of the ratio that should be taken into account.
- Net income, which is used in the formula, does not always equal cash flow. A company can report a high net income, yet in reality, does not have sufficient cash available to make dividend payments.
- DCR norms vary by industry, so there is no universal 'ideal' level of DCR.
- Net income can significantly change with each year, hence the use of historical financial records to calculate DCR is not necessarily the most reliable.