Concepts Behind Dividend Coverage Ratio
The dividend coverage ratio as the name suggests is the ratio of company's earnings over the dividend paid to the share holders, it is calculated as net profit or less to the shareholders by total ordinary dividend. Dividend coverage ratio actually reflects the number of times any company is capable of paying dividends to share holders, from the profit it earned in an accounting period. For any ordinary share the dividend coverage ration can be calculated as, the subtraction of the profit after tax and the dividend paid on irredeemable preference shares divided by the dividend paid for the ordinary share to the shareholders. For example if the dividend coverage ratio for a company turn puts to be 4, it implies that the company has the earnings which are sufficient to pay dividends amounting to four times of the present dividend payout for a considered period.
The dividend coverage ratio is used by the company to evaluate its ability to pay dividends. The companies try to maintain the reasonable level of the dividend coverage ratio as per the expectations of the market. In an ideal situation, the companies try to maintain their ratio as 2, in order to have the adequate financing and to provide the reasonable cash return for the investment of shareholders. In cases where the dividend coverage ratio of the companies comes under 1.5, it depicts that the company many not be able to maintain the level of dividends which it is paying now to the shareholders in case the profit of the companies moves to the lower side. On other hand if the dividend coverage ratio of the companies is high, it means that the shareholders can expect high dividends payout in future. Therefore the dividend coverage ratio is very important for the investors and they use it as tool to measure the dividends which can be paid to the companies.
If a company is a strong, then it will have the high ratio and the paying off the dividends is an easy task for them. The dividend coverage ratio is not only useful for the investors who want to buy new shares but it is also beneficial for the shareholders who already have the share of a company. By the dividend coverage ratio of the company they can have idea then when they are likely to be pad the dividend. If the company's dividend payout ratio is less it means that they have to wait for their dividends.
For example, if there is ABC company who pays the dividend on its ordinary share as 50$ and just for an example it its profit after tax and the dividend on the irredeemable share is 200$. Hence if we divide $200 by 50 we get the dividend coverage ratio as 4.The investors would definitely be interested in this company. So the dividend coverage ratio makes the task of the shareholders easy as to which company they want to chose and therefore any company desire for the decent ratio.
Difficulties Encountered In Dividend Coverage Ratio
The dividend coverage ratio is easy to understand as far as its definition is considered but the concept behind the definition is complex. The students don't just get the assignments where they have to simply calculate the ratio, the problems of dividend coverage ratio are made complex by asking the students to the earnings after the tax paid by the company. The students also get confused between the redeemable shares and irredeemable shares. The problems assigned to the students are not that simple where they have to just calculate the figure of ratio and everything else is given, in fact they are given the complex problems. The concept of dividend coverage ratio is also a little tough where the students are asked to derive the various possibilities' out the ratio. Therefore the students sometimes get stuck up in between the tricky calculations even though the concept of dividend payout ratio is clear to them.
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