Dividend Coverage Ratios based on Net Income and Free Cash Flow

Net Income

The dividend coverage ratio (Net income/Dividends) and dividend payout ratio (Dividends/Net income) are traditional ways to evaluate dividend safety. A lower dividend coverage ratio or higher dividend payout ratio suggests a higher risk of a dividend cut, since a small decline in earnings could cause the dividend not to be paid out of the earnings.

Example: Calculating the Dividend Coverage Ratio using Net Income

Given the following data, calculate the dividend payout ratio and debt coverage ratio.

• Net income available for common stock: $200 million
• Dividends paid: $50 million.

Solution

$$\text{Dividend payout ratio}=\frac{\text{Dividend}}{\text{Net income}}=\frac{50}{200}=0.25=25\%$$

$$\text{Dividend coverage ratio}=\frac{\text{Net income}}{\text{Dividend}}=\frac{200}{50}=4\text{x}$$

A dividend coverage ratio below 1.0 implies that the dividend is in jeopardy unless events such as employee strikes or storms are the reason for the decrease in earnings.

Free Cash Flow

Free cash flow is the cash flow available for distribution in dividends after working capital and fixed expenditures have been deducted. Ignoring capital expenditure needs and distributing dividends to shareholders may be contrary to maximizing the wealth of shareholders. Cash flows from free cash flow to equity (FCFE) can be viewed as a source of cash dividends payments.

$$\text{FCFE coverage ratio}=\frac{\text{FCFE}}{(\text{Dividends}+\text{Share repurchases})}$$

A ratio of 1 shows that a company returns all available cash to shareholders. A ratio greater than 1 implies that a company is increasing its liquidity by using funds to increase shares or cash. A ratio less than one means that the company reduces its liquidity by paying out more than it can afford.

Example: Calculating Coverage Ratio using Free Cash Flow

The following are details of Medusa Ltd:

• Net income for the year: $400 million.
• Cash flow from operations: $500 million.
• FCInv (capital expenditure): $412 million.
• Net borrowings: $12 million.
• Dividend paid: $13 million.
• Stock repurchases: $10 million.

Calculate the FCFE coverage ratio for the year.

Solution

$$\begin{align*}\text{FCFE}&=\text{Cashflow from operations (CFO)}-\text{FCInv}+\text{net borrowing}\\&=$500\ \text{million}-$412\ \text{million}+$12\ \text{million}\\&=$76\ \text{million}\end{align*}$$

$$\begin{align*}\text{FCFE Coverage ratio}&=\frac{\text{FCFE}}{[\text{Dividends}+\text{Share repurchases}]}\\&=\frac{$76\ \text{million}}{($13\ \text{million}+$10\ \text{million})}\\&=3.3\text{x}\end{align*}$$

Question

Global communication has the following details:

• Net income: $600 million.
• Dividends: $100 million.

The dividend coverage ratio is closest to:

1. 0.1667x.
2. 6x.
3. 67x.

Solution

The correct answer is B.

$$\text{Dividend coverage ratio}=\frac{\text{Net income}}{\text{Dividend}}=\frac{600}{100}=6\text{x}$$

A is incorrect. 16.67% is the dividend payout ratio, \(\frac{\text{1}}{\text{6}}\).

Reading 18: Analysis of Dividend and Share Repurchases

LOS 18 (m) Calculate and interpret dividend coverage ratios based on 1) Net income and 2) Free cash flow.