What is the Preferred Dividend Coverage Ratio?

Key Highlights

• The preferred dividend coverage ratio evaluates a company's ability to pay dividends to its preferred shareholders based on its net income.

• A ratio above 1 suggests that the company can pay preferred dividends. However, a ratio below 1 suggests it will default on dividend payments.

• Investors should also consider other financial ratios like interest coverage and debt service ratios to determine if a company can pay its debt holders.

• The dividends preferred shareholders are usually predetermined. However, the board of directors decides the amount of dividends for common shareholders.

Preferred Dividend Coverage Ratio Meaning

The coverage ratio calculates a company's net income and determines if it is enough to pay the fixed dividends on its outstanding preferred shares. It is also known as the times preferred dividend earned ratio. It serves as a valuable tool for all investors and debt holders in assessing the financial stability of a firm.

Banks and other creditors will use this ratio to assess how much debt the business can manage. This coverage ratio should even be known to shareholders of ordinary stock, as it may impact dividends on common shares.

A company should have more profits than it needs to pay the dividends. However, this isn't always the case. A coverage ratio of 1 suggests that the business can pay its preferred dividend. When it is less than 1, it suggests the company will default on its dividend payments.

Formula of Preferred Dividend Coverage Ratio

After understanding the preferred dividend coverage ratio meaning, let’s look at its formula. The Preferred Dividend Coverage includes two key components. They are as follows.

• Net Income after Taxes: The amount left after subtracting all the expenses, interest, taxes, depreciation, and amortisation from the company's revenue.

• Preferred Dividend: The total dividend amount preferred shareholders will receive as per the preferred stock offering.

The preferred dividend coverage ratio formula is as follows:

PDC = Net Income after Taxes / Preferred Dividend

Example: Suppose Company ABC recorded Rs, 1,00,000 in net income for a quarter. The company must pay out 7% for every preferred share. A total of 5,000 preferred shares, each worth Rs,160. They have paid out preferred dividends consistently till now. So, currently, there is no outstanding balance.

The calculation is as follows:

Preferred dividend per share = Preferred share dividend rate * Preferred share price = 7/100 * Rs. 160 = Rs. 11.20

Total annual preferred dividend payment = Preferred dividend per share * Number of preferred shares = Rs. 11.20/share * 5,000 shares = Rs. 56,000

Preferred dividend coverage ratio = Net income / Annual preferred dividend payment = Rs. 1,00,000 / Rs. 56,000 = 1.7857

Therefore, the preferred dividend coverage ratio for Company ABC is 1.7857.

Interpreting Preferred Dividend Coverage Ratio

Preferred dividend payments do not depend on the company's profitability. However, a company with a net loss or low net income may have a low preferred dividend coverage ratio. There is a significant risk of defaulting on the payments. If a firm’s net income and preferred dividend coverage ratio are high for several years, it is considered a safe issuer.

Further, a constantly high preferred dividend coverage assures shareholders that dividends will be available in the future. A low ratio may impact the value of common stocks. This is because the firm may not be able to pay dividends to both preferred and common stockholders.

Investors should also check coverage at higher levels if a company has low preferred dividend coverage. These include the interest coverage ratio or the debt service ratio. This helps to determine if the business is strong enough to pay its debt holders. This is especially important for the preferred shareholders. It is because they have a lower claim than debt-holders like bondholders and lenders.

Difference Between Preferred and Common Dividends

A public company may obtain funding from several sources. These include bonds, loans, and preferred or equity shares. Equity shareholders are also referred to as common shareholders. The firm must generate revenue and share profits with its investors. The distribution of the earnings follows a preferential order. Companies must pay as per a fixed or floating rate of return.

Debt holders have the highest rank to get a fixed percentage. Still, they get the lowest expected return on investment. The next position belongs to preferred equity shareholders. They get their payments as preferred dividends. They receive more than common shareholders but lower for common shareholders. The common shareholders hold the last position. They earn the highest returns. This is because they take the maximum risk.

The dividend distribution for preferred shareholders is predetermined. However, the company's board of directors determines the dividend payout for common shareholders. Preferred dividends are distributed before common dividends. The payout can be a fixed or variable rate. It is based on an interest rate benchmark such as the LIBOR. Generally, it is distributed annually or quarterly.

Conclusion

Analysing key financial ratios is essential for trading in the share market. The dividend coverage ratio is one of them. It measures a company's net income to determine whether it can pay the preferred dividends. It serves as an indicator of future risk. A high preferred dividend coverage ratio is always preferable. It guarantees that a firm can provide its dividends to its shareholders. A firm may be unable to pay future dividends if the ratio is very low. So, it's crucial to check the dividend coverage ratio before investing in any firm.