Dividend Policy and Dividend Cover

he dividend policy and dividend cover of a company are important factors to understand about an investment. Analysts want to understand and measure the likely return from a company before an investment is made and then at regular intervals.

One way of doing this is to assess whether a firm has a stable payment policy. Do they increase their payments in an orderly and regular way? Are payments made at a constant rate? Will the firm be able to maintain these payments?

One measure used to help answer these questions is a ratio known as dividend cover. Dividend Cover = Earnings Per Share divided by Dividend Per Share

The inverse of this ratio is the proportion of earnings that belong to ordinary shareholders which are distributed to them. This is known as the dividend payout ratio.

A company who has a dividend cover ratio of 1.0 pays out all earnings in dividends. This means that should earnings fall, the company might be forced to cut annual dividend payments. If the company has financial reserves, it may be able to make the annual payment from these cash reserves in the short term.

Many firms use annual dividend payments as a signal to shareholders and the market of confidence, so in the short term, directors will be reluctant to reduce payments, unless the firm is in trouble.