dividend cover: calculation and interpretation

10.2 Analysis of Published Accounts – Investment Ratios

Learning Outcomes

• Identify the line‑items required from the profit & loss account and balance sheet for ratio calculations.
• Calculate the main investment ratios used by investors and analysts.
• Interpret the results and explain what they reveal about a company’s profitability, liquidity, market perception and dividend policy.
• Appraise the limitations of ratio analysis and relate findings to business objectives, dividend policy and stakeholder expectations.

1. Quick Refresher – Key Financial Statements

Statement	Key Line‑Items Used in Ratio Analysis
Statement of Profit or Loss (Income Statement)	Revenue, Cost of Sales, Gross Profit, Operating Profit (EBIT), Profit Before Tax, Tax Expense, Profit After Tax (PAT), Preferred Dividends, Ordinary Dividends.
Statement of Financial Position (Balance Sheet)	Current Assets, Current Liabilities, Total Assets, Fixed Assets, Share Capital, Retained Earnings, Total Equity, Long‑term Debt.
Cash Flow Statement (or notes)	Cash paid for dividends, cash received from financing activities, operating cash flow.

2. Core Investment Ratios

2.1 Dividend Cover

• Definition: The number of times the profit available for distribution can cover the total ordinary dividend paid.
• Formula: \[ \text{Dividend Cover}= \frac{\text{Profit Available for Distribution}}{\text{Total Ordinary Dividends Paid}} \] where Profit Available for Distribution = PAT – Preferred Dividends (if any).
• Calculation steps
  1. Extract PAT from the income statement.
  2. Subtract any preferred dividend obligations.
  3. Locate the total ordinary dividend declared (cash‑flow statement or notes to the accounts).
  4. Apply the formula.

Dividend Cover	Interpretation
< 1.0×	Dividends exceed profits – unsustainable; likely to be reduced.
1.0–1.5×	Very thin margin; dividend at risk if profits fall.
1.5–2.0×	Acceptable for many mature firms; modest safety buffer.
2.0–3.0×	Comfortable level; investors view dividend as reliable.
> 3.0×	Strong cover – may indicate scope to increase dividends or retain earnings for growth.

Worked Example – Dividend Cover

Item	£ ‘000
Profit after tax (PAT)	3,900
Preferred dividends	200
Ordinary dividends declared	1,300

Profit available for distribution = 3,900 – 200 = 3,700

Dividend cover = 3,700 ÷ 1,300 = 2.85×

Interpretation: a comfortable buffer; the dividend is likely sustainable and a modest increase could be considered.

2.2 Dividend Yield

• Definition: The return to shareholders expressed as a percentage of the market price of a share.
• Formula: \[ \text{Dividend Yield}= \frac{\text{Ordinary Dividend per Share}}{\text{Market Price per Share}}\times 100 \]
• Interpretation:
  • Higher yield attracts income‑seeking investors.
  • Very high yields may signal a falling share price or an unsustainably high dividend.

Worked Example – Dividend Yield

Item	£ ‘000
Total ordinary dividends declared	800
Number of ordinary shares (average)	1,200
Market price per share	15

Dividend per share = 800 ÷ 1,200 = £0.667

Dividend yield = (0.667 ÷ 15) × 100 = 4.44 %

2.3 Earnings‑Per‑Share (EPS)

• Definition: Profit attributable to each ordinary share.
• Formula: \[ \text{EPS}= \frac{\text{Profit Available for Distribution}}{\text{Weighted Average Number of Ordinary Shares Outstanding}} \]
• EPS is the numerator in the Price‑Earnings (P/E) ratio.

Worked Example – EPS

Item	£ ‘000
Profit after tax (PAT)	2,400
Preferred dividends	100
Number of ordinary shares (average)	1,200

Profit available for distribution = 2,400 – 100 = 2,300

EPS = 2,300 ÷ 1,200 = £1.92 per share

2.4 Price‑Earnings (P/E) Ratio

• Definition: The multiple the market is willing to pay for each pound of earnings.
• Formula: \[ \text{P/E Ratio}= \frac{\text{Market Price per Share}}{\text{Earnings per Share}} \]
• Interpretation:
  • High P/E – market expects strong future growth.
  • Low P/E – may indicate undervaluation or perceived risk.

Worked Example – P/E Ratio (using XYZ Ltd data)

Item	Value
EPS	£1.92
Market price per share	£15.00

P/E = 15 ÷ 1.92 = 7.81

Interpretation: a modest multiple; investors may view the firm as fairly valued or as having limited growth expectations.

2.5 Return on Capital Employed (ROCE)

• Definition: Profitability ratio showing how efficiently a company generates profit from the capital it employs.
• Formula: \[ \text{ROCE}= \frac{\text{Operating Profit (EBIT)}}{\text{Capital Employed}} \times 100 \] where Capital Employed = Total Assets – Current Liabilities (or Equity + Long‑term Debt).
• Interpretation: Higher ROCE indicates more efficient use of capital; useful for comparing firms in capital‑intensive industries.

2.6 Other Common Ratios (Liquidity & Leverage)

• Current Ratio – liquidity: \[ \text{Current Ratio}= \frac{\text{Current Assets}}{\text{Current Liabilities}} \]
• Quick Ratio – liquidity excluding inventory: \[ \text{Quick Ratio}= \frac{\text{Current Assets – Inventory}}{\text{Current Liabilities}} \]
• Debt‑to‑Equity Ratio – financial leverage: \[ \text{Debt‑to‑Equity}= \frac{\text{Total Debt}}{\text{Total Equity}} \]
• Gross Profit Margin – profitability: \[ \text{Gross Profit Margin}= \frac{\text{Gross Profit}}{\text{Revenue}}\times 100 \]

Worked Example – Current Ratio (using XYZ Ltd figures)

Item	£ ‘000
Current Assets	5,500
Current Liabilities	2,500

Current Ratio = 5,500 ÷ 2,500 = 2.20

3. Linking Ratios to Business Objectives & Stakeholder Expectations

• Dividend Cover & Yield – directly inform the dividend‑policy objective (stable or growing returns to shareholders).
• EPS & P/E – signal earnings growth and market valuation; useful when the objective is to attract equity investors or assess share‑price expectations.
• ROCE – measures efficiency of capital use; aligns with a growth or profitability objective.
• Current & Quick Ratios – indicate short‑term liquidity; important for creditor confidence and for firms that prioritise low financial risk.
• Debt‑to‑Equity – reflects financial leverage; relevant when the business is deciding between debt‑financing and equity‑financing.

Strategic Decision‑Making – What the Ratios Suggest

• Low dividend cover (< 1.0×) → consider reducing the dividend or retaining more earnings for reinvestment.
• High dividend yield (> 5 %) with a low cover → investigate sustainability before promising investors.
• ROCE below industry average → may need cost‑reduction, asset disposal, or a shift in strategy.
• Current ratio < 1.0 → risk of liquidity problems; could prompt tighter working‑capital management.
• P/E significantly higher than peers → market expects growth; ensure growth projects are viable.

4. Limitations of Ratio Analysis

• Ratios are based on historical accounting figures; they may not reflect current cash‑flow realities.
• One‑off items (e.g., asset disposals, restructuring costs) can distort profitability ratios.
• Different accounting policies (depreciation methods, inventory valuation) hinder comparability between firms.
• Ratios give no indication of future market conditions, competitive threats, or macro‑economic changes.
• Over‑reliance on a single ratio can lead to mis‑interpretation; a balanced set of ratios is essential.

5. A‑Level Extension – Investment Appraisal Techniques (Topic 10.3)

These methods are not required for AS‑Level but are useful for A‑Level study and for understanding how investment decisions affect future dividends.

Method	Key Formula / Concept	When It Is Most Useful
Payback Period	Number of years required for cumulative cash inflows to equal the initial outlay.	Quick assessment of liquidity risk; ignores time value of money.
Accounting Rate of Return (ARR)	\(\displaystyle \text{ARR}= \frac{\text{Average Accounting Profit}}{\text{Initial Investment}}\times100\)	Useful when cash‑flow data are unavailable; does not consider discounting.
Net Present Value (NPV)	\(\displaystyle \text{NPV}= \sum_{t=0}^{n}\frac{C_t}{(1+r)^t}\) where \(C_t\) = net cash flow in year t, \(r\) = discount rate.	Preferred method – incorporates time value of money and all cash flows.
Internal Rate of Return (IRR)	Discount rate that makes NPV = 0.	Used to compare projects of different sizes; must be cross‑checked with NPV.

6. Full Worked Example – XYZ Ltd (2024)

Item	£ ‘000
Revenue	12,000
Cost of Sales	7,200
Operating Profit (EBIT)	3,200
Profit Before Tax	3,200
Tax Expense	800
Profit After Tax (PAT)	2,400
Preferred Dividends	100
Ordinary Dividends Declared	800
Number of Ordinary Shares (average)	1,200
Market Price per Share	15
Total Current Assets	5,500
Total Current Liabilities	2,500
Total Assets	10,000
Total Debt (long‑term)	2,000
Total Equity	8,000

Calculations

• Dividend Cover = (2,400 – 100) ÷ 800 = 2.88×
• Dividend Yield = (800 ÷ 1,200) ÷ 15 × 100 = 4.44 %
• EPS = (2,400 – 100) ÷ 1,200 = £1.92 per share
• P/E Ratio = 15 ÷ 1.92 = 7.81
• ROCE = (3,200 ÷ (10,000 – 2,500)) × 100 = 45.7 %
• Current Ratio = 5,500 ÷ 2,500 = 2.20

Interpretation Snapshot

• Dividend cover > 2.5× – dividend appears safe; modest increase could be contemplated.
• Yield of 4.44 % is attractive relative to comparable equities.
• P/E of 7.8 suggests the market values the firm modestly; may reflect perceived risk or limited growth expectations.
• ROCE of 45.7 % indicates very efficient use of capital.
• Current ratio of 2.20 shows strong short‑term liquidity.

7. Practice Questions

1. Company A reported PAT of £4.5 million, paid preferred dividends of £0.5 million and declared ordinary dividends of £1.0 million.
   • Calculate the dividend cover.
   • Comment on the sustainability of the dividend.
2. Explain why a dividend cover of 0.9× is a warning sign for investors. Suggest two actions the company might take in response.
3. Given the data below, compute the dividend cover and discuss whether the company should consider increasing its dividend:
   • PAT = £2.8 million
   • No preferred dividends
   • Ordinary dividends declared = £0.8 million
4. Using the XYZ Ltd figures above, calculate the P/E ratio and discuss what a P/E of 7.8 might imply for investors.
5. Briefly outline the difference between the Payback Period and Net Present Value (NPV) methods of investment appraisal, and state which you would recommend for a project with irregular cash flows.