Calculating the Ratio
Floating Steamroller Corporation intends to continue its current dividend strategy which involves paying out $80,000 in dividends per year. Any change in the dividend policy would unsettle shareholders, damage confidence in the company and send the share price down. The company is, however, concerned about its ability to meet all its other obligations and therefore wishes to compute its dividend coverage. The forecast profit in the first year is $220,000, and the depreciation taken into account in computing the profit is $20,000. If the depreciation is added back to the profit this gives operating cash flow of $240,000 to cover the dividend payments of $80,000, resulting in dividend coverage of 3.0. This would probably be regarded as an acceptable dividend coverage enabling the company to meet its dividend payments and other payments as they fall due.
In the second year, the forecast net profit is $180,000 and a depreciation charge of $20,000 is deducted in computing the profit. If the depreciation charge is added back to net profit giving operating cash flow of $200,000 to cover the dividends of $80,000, the dividend coverage is 2.5 in the second year. The ratio is therefore well above 1.0 but the company might want to look more closely at the other projected payments falling due so as to assess its ability to continue paying the same level of dividends.
In the third year, the net profit is projected to fall to $100,000, after accounting for depreciation of $20,000. After adding back depreciation there is an operating cash flow of $120,000 to cover dividends of $80,000. The dividend coverage in the third year is therefore 1.5, which although it is still above 1.0 may not be enough to give assurance to management that there will be sufficient cash available to pay the dividend and cover other payments falling due.
Based on these forecasts, management might want to look in more detail at the profit forecasts and at any other payments the company is forecast to make in these periods. They might also want to study cash flow projections that include all cash inflows and outflows over the relevant period. The results of the detailed cash flow projections would guide the management decision on dividend policy into the future.