Dividend cover is used by investors to assess the sustainability and safety of a company’s dividend payments. It is also referred to as “dividend coverage ratio” or “earnings dividend coverage.”
Dividend cover is calculated by dividing a company’s earnings by the total amount of dividends it pays out to its shareholders. The formula for dividend cover is as follows.
Earnings (profit after tax) / Total dividends paid
Dividend cover is primarily used to determine if a company is generating enough profit to cover its dividend payments. In other words, it helps investors assess whether a company can sustain its current dividend policy. If a company consistently has a dividend cover below one, it suggests that it may be paying out more in dividends than it is earning in profit, which may not be sustainable over the longer term.
A high dividend cover indicates that there is a strong financial cushion to support dividend payments even during difficult economic times. It implies a lower risk of dividend cuts or suspensions. Conversely, a low dividend cover raises concerns about the reliability of dividends and can lead to reduced investor confidence.
Investors can use dividend cover to compare different companies within the same industry or sector. A higher dividend cover might indicate a more conservative dividend policy, whereas a lower cover may suggest a more aggressive or risky approach.
Monitoring changes in dividend coverage over time can provide insights into a company’s financial health. A declining cover might signal financial stress or a need to reevaluate the dividend policy.
It’s important to note that what constitutes an acceptable dividend cover ratio can vary by sector, company size, and the specific circumstances of the business. Some companies, particularly those in mature and stable industries, may have lower dividend cover ratios but still be considered financially sound because they have consistent and predictable cash flows. Other companies in growth sectors or those with high capital requirements may maintain higher cover ratios to ensure they can reinvest in their operations.
In summary, dividend coverage can be a good tool for investors to assess the sustainability and safety of dividend payments. It can help in making informed investment decisions and understanding a company’s financial health in relation to its dividend policy.