To determine how stable a company’s dividends are, investors calculate the cash dividend coverage ratio. One way to help determine the stability of a company’s dividends is by estimating the company’s ability to meet its dividend payouts using only operating cash flows.
The use of operating cash flows helps indicate whether a company’s core operations are contributing to financial strength, which, in turn, helps investors estimate whether related metrics are stable.
Here's the formula to calculate the cash dividend coverage ratio:
Follow these steps to use this equation:
Find the operating cash flows in the operating cash flows portion of the statement of cash flows and the cash dividends near the bottom of the income statement.
Divide the operating cash flows by the cash dividends to find the cash dividend coverage ratio.
For investors who prefer stocks that issue dividends, this ratio can help them determine whether a company will continue to have stable dividends. It also doubles as a way for other investors, as well as management, to calculate the competitive strength and financial efficiency of the company.
After all, in a way, the cash dividend coverage ratio represents the company’s ability to generate earnings beyond what’s required for the current rate of growth using only its core operations.