What it means
Preference shares, also called preferred stock, sit between debt and ordinary shares: holders receive a fixed dividend before ordinary shareholders get anything, but they cannot force the company into insolvency if a payment is skipped. The coverage ratio measures the cushion between the profit available and that fixed obligation, expressed as a simple multiple.
Investors who buy preference shares are buying an income stream, so their first question is whether the income is safe. Credit analysts watch the same number because a company straining to pay preferred dividends is usually straining to pay everything else.
Boards use it as a sanity check before declaring a payout. The calculation is net income after tax divided by the annual preferred dividend.
It is deliberately taken after tax because preferred dividends are paid out of post tax profit, which is the key difference from interest cover, where pretax profit is used because interest is deducted before tax. Many preference shares are cumulative, meaning any missed dividend accumulates and must be cleared in full before ordinary shareholders receive a penny.
When arrears exist, careful analysts add them to the denominator to test whether the company can catch up as well as keep current. Profit is an accounting figure, so a comfortable looking ratio can sit alongside an uncomfortable bank balance.
Cross checking against operating cash flow avoids the awkward position of a well covered dividend that the company cannot physically fund.
In practice
Real-world examples.
Example
A regional bank issues $50,000,000 of preference shares to strengthen its capital base. Its investor relations team reports coverage of 6.2 times each quarter because institutional buyers of the shares treat any fall below 3 times as a reason to sell.
Example
A hotel group hit by a weak season sees coverage drop from 4.1 times to 1.3 times in a single year. The board pays the preferred dividend anyway, but suspends the ordinary dividend to preserve cash, which is precisely the priority order the share terms require.
Example
A private manufacturer uses cumulative preference shares to bring in an outside investor without giving up voting control. When two years of dividends are missed during a factory rebuild, the arrears of $1,800,000 must be cleared before the founders can take anything out of the business.
Think of it
“This shows how many times your earnings could pay preferred dividends-safety margin for preferred.
Formula
Calculation
Preferred dividend coverage ratio = net income after tax / annual preferred dividends
A specialist engineering group reports net income after tax of $12,000,000 for the year. It has 3,000,000 preference shares in issue, each entitled to a fixed annual dividend of $0.80, so the total preferred dividend bill is 3,000,000 x $0.80 = $2,400,000.
Coverage = $12,000,000 / $2,400,000 = 5.0 times. That is a comfortable margin. If a weak year cut net income to $3,000,000, coverage would fall to $3,000,000 / $2,400,000 = 1.25 times, meaning only $600,000 of profit would be left after the preference holders were paid.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Kestrel Marine Supplies, an invented boat parts distributor, raised $40,000,000 through preference shares to fund three warehouse acquisitions, promising a fixed 6% annual dividend of $2,400,000.
In the first two years net income ran at roughly $11,000,000, giving coverage above 4.5 times, and nobody thought about the ratio at all. When a shipping cost spike pushed net income down to $2,600,000, coverage fell to just over 1.1 times, and the fictional board discovered that its bank covenants required coverage of at least 2 times before any ordinary dividend could be declared.
Kestrel's finance director rebuilt the forecast around coverage rather than around profit, cutting discretionary spending until the ratio recovered above 3 times. The episode taught the illustrative management team to treat the preferred dividend as a fixed cost of running the business rather than as a discretionary distribution.
Watch out
Common mistakes.
- Using pretax profit in the numerator, which flatters the ratio because preferred dividends are actually paid out of profit after tax.
- Ignoring accumulated arrears on cumulative preference shares, so the ratio describes only this year's obligation rather than the full backlog.
- Assuming a high ratio guarantees payment, when the company may have profit on paper and no available cash to distribute.
Questions
People also ask.
What is a healthy preferred dividend coverage ratio?
Most analysts want at least 2 times, and anything under 1.5 times is treated as a signal that the payment is fragile.
Does the ratio include ordinary dividends as well?
No, it covers only the fixed preferred payment, since ordinary dividends are discretionary and rank behind it.
What happens if coverage falls below 1?
The company is paying preference holders out of reserves or borrowings rather than current profit, which is not sustainable for long.
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