Work out and explain how well dividends are covered, measured against free cash flow and against net income
The idea
Coverage ratios test how comfortably earnings or cash flow support distributions. The net income version is net income ÷ dividends, the inverse of the payout ratio: 400 of earnings against 160 of dividends gives coverage of 2.5. The cash flow version compares free cash flow to equity with what is actually paid out, usually dividends plus repurchases, because both consume cash. A ratio below 1 means distributions exceed internally generated cash and must be met from reserves or borrowing. Net income can overstate what is available when capital spending or working capital absorbs cash. Traps include inverting the ratio and leaving repurchases out of the FCFE denominator when the definition includes them.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Set out what shapes the dividend policies companies actually adopt
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- Outline how corporate payout policies have broadly changed over time
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