Dividend Coverage Ratio: How Many Times Earnings Pay It

A dividend that is paid out of earnings can survive a bad year. One eating most of the earnings usually cannot. Coverage tells the two apart, from two lines of the annual report.

Coverage on earnings and on cash

A hypothetical company reports diluted EPS of $3.00. It pays $2.00 a share in dividends. Its cash flow statement shows free cash flow of $2.40 a share, which is operating cash flow minus capital spending, divided by the diluted share count the income statement uses.

On earnings, the dividend is covered one and a half times. On cash, barely more than once.

The gap between the two readings is the thing to chase. Earnings include non-cash items. If profit is flattered by a non-cash gain, or if capital spending runs well above depreciation because the company is growing or catching up on maintenance, cash coverage will be thinner than the earnings figure suggests, and the dividend is ultimately paid in cash, so cash is the reading to lean on when the two disagree.

How far earnings can fall

Coverage converts straight into a cushion. Divide 1 by the coverage ratio and subtract the result from 1, and you get the share of earnings the company could lose before the dividend costs more than it earns.

A third is a decent buffer for a steady business. A sixth is not much for one whose profits swing with the economy, since a single weak year can take that much out of free cash flow, and the board then has to choose between borrowing to hold the payout and cutting it.

Where to find the numbers in a filing

The 10-K income statement gives EPS, basic and diluted. Use diluted. Dividends declared per share usually sit in a note to the financial statements or in the equity section, and for cash coverage you take operating cash flow and capital expenditures from the cash flow statement, subtract one from the other and divide by the diluted share count. Company-reported free cash flow varies by definition. Check what was left out.

The trend matters more than the level

One year’s coverage is a snapshot. Several years tell you where it is going.

Earnings went nowhere. The dividend rose a third.

Each year’s increase looked generous on its own, and each year’s coverage still looked comfortable, yet the company spent four years handing out a growing share of flat profits, which leaves less room for the next bad year and makes the next increase harder to fund. That’s a pattern to catch before a freeze or a cut arrives, and it’s the one the case for planning around the next dividend cut builds on. The dividend cut calculator sizes the income hit.

Sector norms

Coverage levels differ by industry, so compare like with like. Utilities often run high payout ratios because their regulated revenue is steadier than most. REITs are built to pass most of their income to holders and routinely show earnings coverage near or below one, which is why they are better judged on funds from operations, a measure that adds back real estate depreciation. EPS coverage below one can be fine on FFO.

What people get wrong

Relying on earnings coverage alone is the most common mistake. When earnings carry large non-cash items, cash coverage is the better test.

Another is using adjusted EPS from the press release. Adjusted figures drop costs labeled one-time. Those costs still use cash when they recur.

Last, people read any coverage above 1 as safe. At 1.2 the cushion is under a fifth. After a cut, see replacing lost dividend income.

Related terms

The payout ratio and funds from operations sit closest. A stock dividend pays in shares and needs no coverage in cash. More in the dividends hub.