Companies pay dividends to shareholders out of their profits. Directors decide what proportion of profits they will distribute: the amount varies depending on how well the company has done.
When assessing the financial health of a company, looking at ‘dividend cover’ can offer a guide as to how likely it is that the dividend will remain stable or rise in the future. It measures the number of times greater the net profits available for distribution are than the dividend payout.
A firm that makes £10m in profit and allocates £1m for dividends has a cover of ten and a firm that makes £25m but pays out £12.5m in dividends has a cover of just two.
A ratio of two or more suggests the dividend is so affordable that it will at least not fall. A ratio below 1.5 suggests the dividend might be at risk.
• See Tim Bennett’s video tutorial: A beginner’s guide to dividends.