Chartered Financial Analyst Level 2
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26 An analyst gathers the following information of three companies in the same industry:
| Company A | Company B | Company C |
|---|---|---|
| Dividend coverage ratio (x) | 3.13 | 2.50 |
| Debt ratio | 37% | 22% |
If the earnings of all three companies are expected to decline by 20% due to a business downturn, which company has the highest risk of a dividend cut?
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A
Company A
B
Company B
C
Company C
Explanation:
Explanation
The dividend coverage ratio measures a company's ability to pay dividends from its earnings. It's calculated as:
Dividend Coverage Ratio = Earnings per Share / Dividends per Share
A higher ratio indicates better dividend safety, while a ratio close to 1 indicates that most earnings are being paid out as dividends, leaving little buffer.
Analysis:
- Company A: Dividend coverage ratio = 3.13x
- Company B: Dividend coverage ratio = 2.50x
- Company C: Dividend coverage ratio = 1.12x
After a 20% earnings decline:
- Company A: New coverage ratio = 3.13 × 0.8 = 2.50x (still safe)
- Company B: New coverage ratio = 2.50 × 0.8 = 2.00x (still safe)
- Company C: New coverage ratio = 1.12 × 0.8 = 0.90x (below 1.0, cannot cover dividends)
Key Points:
- Company C has the lowest initial dividend coverage ratio (1.12x), meaning it's already paying out nearly all its earnings as dividends
- After a 20% earnings decline, Company C's coverage ratio drops below 1.0 (0.90x), indicating it cannot fully cover its dividend payments from earnings
- The debt ratios are less relevant here since the question specifically asks about dividend cut risk
- Companies A and B maintain adequate coverage even after the earnings decline
Therefore, Company C has the highest risk of a dividend cut.
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