What is Preferred Dividend Coverage Ratio?

If you owned a portfolio firm, you would wish to keep it operating. Running out of business indicates that the company will be unable to pay off its debts or distribute the due dividends to shareholders. The coverage ratio is a company’s capacity to adequately evaluate its ability to repay its loans and investors. 

The coverage ratio varies depending on the stakeholders engaged in a corporation. The returns, whether in the form of interest or dividends, are allocated based on seniority level. This article describes the preferred dividend coverage ratio. 

Read on to find out what the preferred dividend coverage ratio entails and how to calculate it. 

Meaning of preferred dividend coverage ratio

The dividend of the preferred stock shares is set in advance and is unchangeable. The preferred dividend coverage ratio is a measure of a company’s ability to distribute the required amount to preferred stockholders. A high preference dividend coverage ratio indicates the high ability of a company to pay dividends to its preferred stockholder. A company with a high preferred dividend coverage ratio would have less difficulty in paying the owed preferred dividend.

An analyst uses several ratios to check the financial health of a company. The coverage ratio indicates the ability of a company to pay the pre-determined amount to its preferred shareholders. Therefore, a financially strong company has a high preferred dividend coverage ratio. This shows a company’s sufficiency in fulfilling its obligation to pay the preferred dividends.

Before determining the dividend for common shareholders, it is mandatory to pay the preferred dividends, if applicable. Common shareholders are unlikely to obtain a dividend payment on their holdings if the corporation struggles to meet its preferred dividend obligations.

The preferred dividend coverage ratio may decline if the company issues additional preferred stocks or its net earnings fall. To determine net income, subtract total costs from total revenue.

Benefits of preferred dividend coverage ratio 

The preference dividend coverage ratio is a statistic that calculates a company’s capacity to pay dividends on preferred shares using its available profits. A more excellent preferred dividend coverage ratio is typically regarded as desirable for the following reasons:

1. Financial flexibility: A more excellent ratio implies that the company’s earnings are sufficient to fulfil its preferred dividend commitments, freeing up more capital for investments in growth possibilities or dividend payments to common shareholders.
2. Financial stability: Companies with a greater preferred dividend coverage ratio are viewed as more financially solid and less likely to have difficulty paying their preferred dividend promises, which can increase investor confidence.
3. Credit rating: A more excellent preferred dividend coverage ratio is seen favourably by rating agencies since it indicates a decreased chance of default on preferred dividend payments, which might lead to better credit ratings and cheaper borrowing costs.
4. Investor appeal: Preferred investors are often risk-averse and prefer reliable dividend payouts. A better coverage ratio may make a company’s preferred stock more appealing to investors looking for consistent income streams.

Formula of preferred dividend coverage ratio

Once grasping the meaning of the preference dividend coverage ratio, let’s delve into its preference dividend coverage ratio formula. It comprises two vital elements:

• Net Income after Taxes: The remaining sum post deduction of expenses, interest, taxes, depreciation, and amortisation from company revenue.
• Preferred Dividend: The cumulative dividend for preferred shareholders stipulated in the preferred stock offering.

The preference dividend coverage ratio formula is as follows:

PDC = Net Income after Taxes / Preferred Dividend

Example: Suppose Company ABC, which reported a net income of ₹ 100,000 for a quarter. Each preferred share warrants a 7% payout, with 5,000 shares priced at ₹ 160, and all dividends have been consistently disbursed, leaving no outstanding balance.

Here’s the calculation:

– Preferred dividend per share = Preferred share dividend rate * Preferred share price = 7/100 * ₹ 160 = ₹ 11.20

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

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

Thus, Company ABC’s preferred dividend coverage ratio stands at 1.7857.

Preferred dividend coverage ratio analysis 

Banks, lenders, and other creditors also use the preferred dividend coverage ratio to assess a company’s capacity to repay future debt. This coverage ratio may benefit common stockholders because it applies to all stock dividends. 

These preferred dividends, whether paid quarterly or annually, are comparable to other fixed-income instruments like bonds. Preferred stocks appeal to investors seeking a consistent income boost. These investors are most likely to own the stock for the long term. There are also exchange-traded funds (ETFs) that invest in preferred equities. 

In preference dividend coverage ratio interpretation, understanding that different coverage ratios can shed light on a company’s ability to meet its financial obligations is vital. Because dividends are not considered a norm or required in the market, comparing one firm with a low preference dividend coverage ratio to another that pays no dividends may be inaccurate.

Additionally, preferred dividends are cumulative. This implies that if dividends are not paid within a specified quarter, the amount owed will be carried over to the following distribution. As a result, preferred stockholders need not worry about a missed distribution. Cash flows and costs typically change over the course of a year. When a corporation decides not to pay dividends for a specific quarter, this preference dividend coverage ratio interpretation should not cause alarm. If the ratio looks to be dropping in the following quarters, it is time to examine deeper.

Difference between preferred and common dividends

A public firm may get capital from several sources. These include bonds, loans, and preferred or equity stock. Equity stockholders are also known as ordinary shareholders. The company must create income and share profits with its shareholders. The earnings are distributed in a preferential order. Companies must pay based on a set or fluctuating rate of return. 

Debt holders are the most likely to get a set proportion. Nonetheless, they receive the lowest projected return on investment. The next place is reserved for preferred equity stockholders. They receive preferred dividends. They receive more than common stockholders, albeit at a lesser rate. The common stockholders hold the final position. They have the highest returns. This is because they take the most risk. 

Preferred stockholders get preset dividends. However, the company’s board of directors determines the dividend distribution for common shareholders. Preferred dividends are paid before ordinary dividends. The payout rate might be either fixed or variable. It is based on an interest-rate benchmark, such as the LIBOR. Typically, it is distributed annually or periodically.

Conclusion

If the preferred dividend coverage ratio is low, further investigations are necessary to evaluate the company’s overall strength. A single poor quarter shouldn’t lead to broad conclusions, but comparing coverage ratios across multiple years can provide insight into stability.

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