The Preferred Dividend Coverage Ratio is a measure that tracks a business capacity to pay for its preferred dividends. This metric employs the company’s annual net income to estimate how many time that income covers the payment of such dividends. The higher the coverage ratio, the more capable the company is to cover for these obligations.
What is Preferred Dividend Coverage?
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Preferred dividends are fixed payments made to preferred shares issued by the company. Those preferred dividends are paid periodically, usually annually or quarterly and they have a higher claim than common shares, yet a lower claim to debt obligations such as bank loans and bonds.
The Preferred Dividend Coverage ratio is an important one for both preferred and common shareholders, as it allows them to measure how capable the company is to fulfill its commitments with them. If the Preferred Dividend Coverage is low, common shareholders should be worried as they may not get any profits at all, as preferred shareholders have a higher claim.
These preferred dividends are not subject to variation if the company earns or losses money, but, the payment of the dividends could be suspended and they can be accumulated until a further point in the future if the business decides to do so and the contract provides for such possibility. That being said, the preferred feature of these shares entitle the preferred shareholders to get paid on all of their accumulated dividends before a dividend can be issued for common shareholders.
Preferred Dividend Coverage Ratio Formula
The formula to calculate the Preferred Dividend Coverage ratio is the following:
PDC = Net Income after Taxes / Preferred Dividend
Preferred Dividend Coverage Equation Components
Net Income after Taxes: The resulting amount after deducting a business’ revenues from all costs, expenses, interest payments, taxes, depreciation and amortization.
Preferred Dividend: The total amount of dividends to be paid to preferred shareholders based on the terms and conditions of the preferred shares issue.
The result of the formula will be expressed in number of times the net income covers for the preferred dividends.
Preferred Dividend Coverage Example
Vocal Experts is a company that produces microphones for professional uses through its brand VEX. The company is publicly traded and it has one issue of preferred shares circulating since 4 years ago. The shares have a par value of $25 each with a preferred dividend of $2.5 per share paid annually, with the possibility of accumulating pending dividends for a maximum period of 2 years. The company has 1,000,000 preferred share outstanding.
The company currently issued its annual report and as part of their regular reporting standards they calculate the Preferred Dividend Coverage. The company’s Net Income for the year was $57,800,000.
Here’s how the calculation will go:
PDC = $57,800,000 / ($2.5 * 1,000,000) = 23
According to this calculation, the company is producing a net profit of 23 times the size of the preferred dividends, which means it has an ample capacity to cover for its obligation with preferred shareholders. On the other hand, it also has $55,300,000 available to distribute to its common stockholders.
Preferred Dividend Coverage Ratio Analysis
While the payment of preferred dividends is not dependent on whether the company produces a profit or not, a company that consistently produces a net loss or has a net income so low that it results in a low Preferred Dividend Coverage ratio is exposed to substantial risk of defaulting on such payments.
On the other hand, cumulative preferred stocks, which allow the issuer to accumulate the dividends for a certain period of time if certain conditions are met, eventually affect the return on investment on the preferred shares, as the time value of money will affect the accumulate funds. This means that, cumulative issues are commonly less valuable than non-cumulative ones due to this risk.
A company with a high Preferred Dividend Coverage, such as the one presented in the example, can be seen as a considerably safe issuer, as long as its net income and therefore its Preferred Dividend Coverage ratio has been at a high level for the past few years.
Additionally, a consistently high Preferred Dividend Coverage assures common shareholders that they will have available earnings to distribute as dividends for them for years to come. Eventually, if the ratio is low, it will end up affecting the value of common stocks, as the likelihood that the company may sustain both dividends for its preferred and common stockholders is lower if the Preferred Dividend Coverage results in a low figure.
Finally, given that preferred stockholders have a lower claim than debt-holders such as bondholders and lenders, a low Preferred Dividend Coverage should also prompt the analyst to check coverage at higher levels such as the Interest Coverage Ratio or the Debt Service Ratio to make sure the company is healthy enough to secure payments to its debt-holders, as this will assure the preferred shareholders that the situation for them is optimistic.
Preferred Dividend Coverage Uses, Cautions, & Pitfalls
Given that the Preferred Dividend Coverage Ratio is calculated by using the Net Income of the business, which subtracts all of the associated costs and expenses, the figure may be affected by extraordinary charges or items related to operations that may not be there next year.
Therefore, it will be advised that any non-recurring item that appears in the income statement that reduces the business’ Net Income significantly should be excluded from the calculation and added back to Net Income, as long as there’s enough evidence to conclude that it is a non-recurring charge. Failing to do so will underestimate the ratio and subsequently, the capacity of the business to cover for its preferred dividends, even though the situation is an extraordinary one.
Additionally, any non-recurring gains that increases the Net Income substantially should also be deducted from it, to provide a more accurate picture of how much the business actually produces under normal circumstances to cover for its preferred dividends. In both cases, refining the Net Income figure is key to understand the actual financial position of the company regarding its preferred shares.