Preferred Dividend Coverage Ratio: Measuring Companies Capabilities

Last Updated: 17 Mar 2023

If you owned a portfolio company, you would prefer to keep the business going. Running out of business means, the company would struggle to pay off its debt or the required dividend to its shareholders. The ability of a company to measure its capability to pay off its loan and investors an adequate amount is defined as the coverage ratio.

The coverage ratio is different for various stakeholders involved in a company. The returns, either in the form of interest or dividends are distributed according to the seniority level. This article details what is preferred dividend coverage ratio.

Preferred Dividend Coverage Ratio

The dividend of the preferred stock shares is set in advance and is unchangeable. A measure of a company’s ability to distribute the required amount to the preferred stockholders is known as the preferred dividend coverage ratio. A high preferred 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 most likely have lesser 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 the sufficiency of a company to fulfil its obligation to payout 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 might be lowered if the corporation issues more preferred stocks or its net profits decrease. Net income for the purpose is calculated by subtracting total expenses from total revenue.

Preferred Dividends vs. Common Dividend

A typical public company can have various sources of capital. These sources can be equity shareholders, preferred shareholders, and the debt raised via banks or bonds The equity shareholders are also known as the common shareholders.

The company is liable to its investors to generate profits and distribute them. The profits are distributed in a preferential sequence. The capital raised through debt is given priority and has to pay a fixed or floating rate of return irrespective of the profit/loss.

While debt providers rank at the top for receiving a fixed percentage, their return expectation is the lowest. Preferred equity shareholders stand next to the debt providers in receiving their share of return at a pre-determined rate. They receive their return in terms of preferred dividends which are less than the common shareholders but higher than the loan providers. The highest return is received by the common equity shareholders, receiving at last. The common shareholders bear the maximum risks and are rewarded with a higher rate of return.

The board members of a company decide the dividend payout for the common shareholders whereas the dividend payout for the preferred shareholders is pre-defined. As the name suggests, preferred dividends are paid out before the common dividend is determined. The dividend may be a

fixed rate or a floating rate related to a benchmark interest rate like LIBOR. It is usually paid out on a quarterly or annual basis.

Preferred Dividend Coverage Ratio Formula

Mathematically, a company’s preferred dividend coverage ratio is calculated using the below formula:

Preferred Dividend Coverage Ratio = Net Income / Amount of Annual Preferred Dividends

How can the preferred dividend coverage ratio be used?

For example, QPR Industries is a popular renewable energy company known for paying the highest preferred dividend in the industry. An investment analyst is seeking opportunities in his high-income portfolio for a long-term investment. One of the metrics the investment analyst can use is the preferred dividend coverage ratio. It gives him a perspective on the stability of the company and if the dividends can last long-term for his investors.

According to the financial statements of QPR Industries, its net income was INR 2 crore while the preferred issue’s prospectus revealed it was issued for a par value of INR 1,00,00,000 at 5%. That means its preferred dividend coverage ratio stands at 40 times.

Preferred Dividend Coverage Ratio = (INR 2,00,00,000)/ (INR 1,00,00,000 * 5%) = 40 Times

This 40 times preferred dividend coverage ratio means that the company can cover 40 times the annual preferred dividend with their net profit. Comparing the same ratio among the similar industry indicates which company has the highest capacity to cover the annual preferred dividend with their net profits.

Frequently Asked Questions

What is a preferred dividend?

Ans:A pre-determined rate or amount a company owes to its preferred shareholders is known as the preferred dividends. The dividend for common shareholders is determined after distributing the preferred dividends.

What do you mean by a coverage ratio?

Ans: A coverage ratio is a metric that measures a company’s ability to meet its financial obligations such as interest payments or dividends.

What is the formula for the preferred dividend coverage ratio?

Ans: Preferred Dividend Coverage Ratio of a security is calculated by dividing the required preferred dividend payout by its net income.

Preferred Dividend Coverage Ratio = Net income / Required Preferred Dividend Payout

What does the preferred dividend coverage ratio indicate?

Preferred Dividend Coverage Ratio indicates a security’s ability to pay its preferred shareholders their required dividend.