Dividend ratios are the family of measures built from a dividend and a stated base, and the base is what each one actually measures. Put dividends declared over net income and you have the payout ratio, put the annual dividend per share over the market price and you have the yield, invert the payout ratio and you have the coverage ratio, subtract it from one and you have the retention ratio. The dividend is common to all of them, so any difference between two of these numbers is a difference in denominators.
The Four Dividend Ratios and Their Bases
Each line below is the same dividend measured against a different base.
dividend payout ratio = dividends declared / net income
dividend coverage ratio = net income / dividends declared
dividend yield = annual dividend per share / market price per share
retention ratio = 1 - dividend payout ratioThe payout ratio divides dividends declared by net income for the same period. Its base is the profit the period produced, so it reads as the share of that profit committed to shareholders, and it is the measure the other three are defined against. What a given level of it says about a business, and where each of its two inputs is read from, belong to the dividend payout ratio on its own.
The coverage ratio turns the same two figures over: net income divided by dividends declared. It asks how many times the period’s profit would have covered what was declared. The two are reciprocals, so a firm quoting both is quoting one fact twice.
Dividend yield divides the annual dividend per share by the market price per share. That base is the only one in the family the accounting records never produce, so the yield moves whenever the share price moves while nothing in the ledger changes.
The retention ratio is the complement: one minus the payout ratio, which is the share of the period’s profit kept in the business rather than distributed. Its base is that same net income, and what the kept amount then does to the equity section is the subject of the statement of retained earnings.
Why the Denominators Change the Statement
A high yield and a high payout ratio are not the same statement about a business. The payout ratio can rise with no change to the dividend at all, because earnings fell. The yield can rise with no change to the dividend at all, because the share price fell. Same numerator, two different pieces of news, and only one of them came out of the accounting records.
Where the Inputs Sit at a Period End
The two accounting inputs are outputs of the close rather than inputs to it, so what the ratios disagree on at a period end is the date rather than the source.
A dividend the board has declared and not yet paid converts part of the ownership interest into a creditor claim, the split described in owner’s equity. It sits in dividends payable at the period end and has not touched cash. A ratio built on dividends declared and a ratio built on dividends paid therefore diverge across any period end a declaration straddles, which is why two payout ratios only sit side by side when both were built the same way.
The Book Denominator Is Not the Tax Character
A distribution recorded on the equity roll-forward and a dividend for tax purposes are two measurements of one payment, and only the first is in the ratio.
For purposes of subtitle A, the term dividend means any distribution of property made by a corporation to its shareholders out of its earnings and profits accumulated after February 28, 1913, or out of its earnings and profits of the taxable year, computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year (26 U.S.C. 316(a)). Earnings and profits is a computation of its own and it is not book net income, so a distribution the ratio counted in full can exceed the amount that is a dividend for tax.
The consequence lands on the information return the shareholders receive. What is not a dividend is not reported as one: box 3 of Form 1099-DIV takes nondividend distributions, if determinable, and a corporation that paid nondividend distributions to shareholders files Form 5452 (IRS, Instructions for Form 1099-DIV).
So the amount a payout ratio counted and the amount the shareholders are taxed on can differ on the same payment. Reconciling the two is work the firm does, and none of the four ratios reports it.
Common Questions
In the singular the phrase names no particular measure, so the useful move is to ask what sits underneath it. Earnings underneath give the payout ratio, market price gives the yield, and dividends themselves give the coverage ratio. A number quoted without its denominator cannot be compared with another one.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a trial task lets a firm grade a real block of its own close work before a client’s equity roll-forward depends on it.
