Dividend Policy and Dividend Cover

The dividend policy and dividend cover of a company are important factors to understand about an investment. Analysts want to understand and measure the likely return from a company before an investment is made and then at regular intervals.

One way of doing this is to assess whether a firm has a stable payment policy. Do they increase their payments in an orderly and regular way? Are payments made at a constant rate? Will the firm be able to maintain these payments?

One measure used to help answer these questions is a ratio known as dividend cover. This can also be looked at as a way to assess cash on the balance sheet (this is investor thinking for 'Will they be able to pay me next year?').

Dividend Cover = Earnings Per Share divided by Dividend Per Share

The inverse of this ratio is the proportion of earnings that belong to ordinary shareholders which are distributed to them. This is known as the dividend payout ratio.

A company who has a dividend cover ratio of 1.0 pays out all earnings in dividends. This means that should earnings fall, the company might be forced to cut annual dividend payments. If the company has financial reserves, it may be able to make the annual payment from these cash reserves in the short term.

Many firms use annual dividend payments as a signal to shareholders and the market of confidence, so in the short term, directors will be reluctant to reduce payments, unless the firm is in trouble.

As the dividend paid by a company increases over time and becomes a regular feature, mutual funds or unit trust types of collective investments will buy the stock. These will be 'income' funds, looking for regular payouts. As more funds buy the equity, there will be less in the market and the supply and demand situation will change. Often this will push the market price upwards.

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Company managers with stock options or bonuses linked to the market price will like this and will not then want to cease payments. Such a move could make income funds sell their holdings and soften the price of the stock on the market. That might actually impact management!

Therefore, a dividend policy - once established - is a very valuable thing to management, and safeguarding it is important to them, and you the investor.

What Is Your Dividend Tax Rate?

As you might imagine, the dividend tax rate will differ from country to country. There are two main geographical factors that influence this, they are:

- where is the company paying out the dividend based?- where are you legally resident?

Our dividend tax rate will mainly depend upon the top rate of income tax at which we pay our taxes. There are many different formulas and potential calculations, so this site shall not even try and do this.

Tax rates can vary amazingly. For example, there was a time once in the UK where a dividend payment was taxed at 98%. We would not have believed this if we had not been told and shown by a high level UK civil servant. It takes no skill to add that the rate at which taxes are charged to dividends will impact the total return on any stock investment.

Under such circumstances, there is barely any point in investing in a large (defensive) company. Governments started to realise that if they wanted their nation's economy to be stronger, they needed lots of investment capital available for companies and a population that had the ability to preserve and create wealth. Such high dividend tax rates acted as a brake to these goals.

Through the end of the 1990's and into the 2000's, the rate at which taxation was charged on a share dividend gently fell in many developed countries. The basic tax deducted at source on the payment of a dividend is now around 20% in lots of countries.

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It is worth pointing out though, that in most major nations, basic rates of income tax are deducted at source from the dividend. This means that the cheque you receive has probably had most or all of your tax liability already deducted. This does not mean that you have no responsibility to declare the income though.

There are some nations where an individual is not taxed on this form of income. However, our research leads us to believe that most of these locations are small and sunny islands rather than the major economic powers of the world. As such these payouts are not generally from companies listed on a major world stock exchange, but instead from privately owned businesses.

If you benefit from this situation, the chances are that you aready know this and established the business there for this very reason!

The rules on tax generally change if the person receiving the dividend is not resident in the same country as the company paying the money out. In these circumstances, a withholding tax is applied before payment to ensure that some tax is paid on the dividend somewhere. By going online, you should be able to find a decent w-4 calc that can give you a better idea. If the jurisdiction in which the receiver lives does not tax dividends, it is then up the receiver to deduct it - if possible - from other taxes paid that year.

As always, it is worth taking professional advice from an accountant or financial adviser to help with you individual situation. The tax inspector, Inland Revenue, IRS or whomever, is not generally the organisation that you want to fall foul of.

Other dividend related pages include:

To An Investor, A Dividend Is A Valuable Thing!

The Definition Of A Dividend

Understanding And Calculating A Dividend Yield

How High Is A High Dividend Yield?

Building A Dividend Portfolio

How Does A Scrip Dividend Work And What Is A Scrip Issue?