A high dividend yield can look like free money. Sometimes it is a sign of a generous, healthy company. Sometimes it is a warning that the share price has fallen because investors expect the dividend to be cut. Dividend cover is one of the simplest tools for telling the difference.
What dividend cover means
Dividend cover measures how many times a company’s profits could pay its dividend. The basic calculation is earnings per share divided by dividend per share. If a company earns 50p per share and pays a 25p dividend, its dividend cover is two. In other words, its profits cover the payout twice over.
How to read it
As a rough guide, a cover of two or more is usually seen as comfortable. It means the company could see profits fall significantly and still afford its dividend, while keeping money back to reinvest in the business.
A cover between one and two is more stretched. The company can pay its dividend but has less room for error. A cover below one means the company is paying out more than it earns, using savings or borrowing to fund the dividend. That cannot last forever.
These are rules of thumb, not hard limits. Different industries have different norms. Utilities and some property companies have stable, predictable earnings and often run with lower cover. Cyclical businesses, whose profits swing with the economy, usually need higher cover to be safe.
Why cash matters too
Earnings are an accounting measure, and they can be affected by one-off items. Dividends are paid in cash. That is why many investors also look at free cash flow cover, which compares the cash a company generates after investment with the cash it pays out. A company can report healthy profits but still struggle to pay dividends if its cash flow is weak.
Warning signs
Watch for cover falling over several years, rising debt being used to fund payouts, and a yield that looks far higher than similar companies. An unusually high yield is often the market’s way of saying it does not believe the dividend will last. A profit warning can also put a stretched dividend at risk quickly.
Why UK investors care
The FTSE 100 is known for its dividend payers, with large banks, oil companies, miners and consumer goods groups paying out a significant share of their profits. For investors relying on that income, dividend cover is one of the first checks worth doing. It also links to share buybacks, which are another way of returning cash, covered in our guide to share buybacks.
The bottom line
Dividend cover tells you how comfortably a company can afford its dividend. It is a quick, useful check, especially when a yield looks too good to be true.
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