A dividend cover is a type of assessment or measurement that provides information on the ability of a business to pay out a certain level of dividends. Essentially, the formula helps to demonstrate how many times over the company could pay a certain dividend out of profits generated in a specified period. A basic formula involves dividing the earnings per share with the dividends per share, making it relatively simple to determine if the company could have easily paid out the dividend amount two, three, or more times from the profits.
One of the reasons why assessing the dividend cover is important is that the calculation can help indicate the stability of the company. This stability is not necessarily judged by how many times over the dividends could have been paid out of the profits for the period, but by the fact that the ratio remains more or less constant from one period to the next. For example, a company that consistently generates earnings that would allow the company to pay dividends twice over to investors would be considered just as stable as a company that was able to pay dividends three times over, provided both companies were able to do so from period to period consistently.
For investors who are looking for investments that provide a relatively consistent return in the form of dividends, reviewing the dividend cover history of a company would be important. Doing so would indicate that the company is able to produce revenue that is likely to produce dividends consistently and often within the same general amount. Should the company exhibit a more volatile dividend cover history, perhaps experiencing rather wide variances from one period to another with no apparent recurring pattern, the investor may consider that investment unsuitable, unless he or she likes the idea of taking on additional risk.
It is important that the dividend cover for even the most stable of companies may shift slightly from time to time. For this reason, investors will normally look at the activity over several periods and allow for variances that appear to be linked to some specific reason, such as seasonality. When used to best effect, determining dividend cover can help companies assess their own progress toward stated goals and identify potential issues that may be threatening to undermine the long-term profitability of the business. At the same time, investors can use this tool as a means of identifying investments that fit into their own financial plans.