Dividend Cover

Dividend cover. Companies pay out dividends but it's up to the directors to decide what proportion of profits are to be distributed.

Some companies might want to hold back most of their profits for future re-investment, while others might want to hand over the bulk of it to shareholders.

So for example, a company which makes £10 million in profit and allocates just £1 million for paying dividends has a dividend cover of 10. e.g. the dividend payment is 'covered' 10 times by the pre tax profit.

Conversely, a company which makes £25 million but pays out £12.5 million in dividends has a dividend cover of just 2.

When assessing the financial health of a company, 'dividend cover' offers a useful guide to how safe the dividend will be in future. The higher the figure, the less likely the dividend pay-out will be reduced or passed (dropped altogether) in the future if profits fall.

Quite often, companies may suffer a sharp fall in profits or make losses but they will continue to pay dividends as an indication they expect the poor performance to be temporary only.

If a company is making losses but it's still paying a dividend, it's funding that pay-out from its 'reserves'. But the reserves are ultimately owned by the shareholders and no company can go on paying dividends indefinitely if it continues to notch up losses.

When assessing the financial health of a company, see also earnings per share (EPS) .

Last Updated: June 2007 © Moneyextra.com

MoneyExtra.com recommends you should consider taking independent financial advice before acting on any article. Please contact us for help with your individual circumstances if any assistance is required.