Second quarter 2020 dividend income – importance of dividend cover

Memories of the three months ending 30 June will almost certainly be dominated by the start of lockdowns imposed by global governments in order to avert the spread of Covid-19. The pandemic and economic downturns have taken their toll on businesses with many looking to shore up their balance sheets and cash positions by any means necessary, included the dreaded cuts.

I previously wrote that 2020 has seen a record number of dividend cuts on the UK market. Since that article in early June, 34 more companies (by my count) have announced dividend cuts/suspensions taking the total amount of dividend cuts this year to over £32billion.


I would love to say that things are looking brighter but the truth is there is still much doom and gloom abound in the world of business. As well as this, there are certain non-economic factors at play such as France asking all companies to moderate their dividends this year regardless of whether they have benefited from direct state.


There is so much uncertainty that the majority of forecasts are rendered useless. In situations like this, you shouldn’t count your chickens before they hatch. There has been many instances of companies announcing dividends only for them to scrap them a few weeks down the line. The only dividend that is safe in these testing times are ones that have already hit your account.


Dividend stalwarts such as are BAE Systems, Bunzl, Burberry, Compass, JD Sports, Johnson Matthey, Rightmove and St James’s Place have all suspended or cut their dividends. And if companies such as these are cutting their dividends, lesser companies are to going to take the knife to their dividend if they a haven’t already done so.


Now is the time for realism. We shouldn’t believe that many companies can pay out dividends that are unsustainable.


Investors, now more than ever, should focus on a company’s dividend cover. This is one of the most important measures of dividend sustainability. Dividends are paid out of profits, so the dividend cover ratio looks at the value of the profits divided by the value of the dividends.
The main advantage of the dividend cover ratio is its simplicity.
A ratio of more than one means that companies are retaining some of their profits – this can be used to shore up the balance sheet, invest in the future of the business or to conduct share buy backs.


A ratio of one means that a company is distributing all its profits as dividends. This is not a healthy position to be is as no amount of profit is retained to reinvest in the business.


A ratio below one indicates that dividends are larger than profits. Essentially it means that the company is taking on debt or selling of assets ion order to pay the dividend. For cyclical companies, a ratio below one could be tolerable for a short amount of time.


A negative ratio indicates that a loss making company is paying out a dividend. This is the worst position to be in as it put strain on the balance sheet in a rapid way.


Investors need to look for companies that have sufficient dividend covers. Far too many stocks on the FTSE have cover hovering around 1 and that is why we have seen so many dividend cuts. It is only a matter of time before companies with low cover such as BP announce a dividend cut.


Note that in the above, I have portrayed dividend cover in terms of profits. But the problem with profits is they can be presented in any which way a company likes. Company’s can magic up a profit figure via accounting concepts such as exceptional items and adjustments.


That is why I personally prefer to use free cash flow (FCF). Free cash flow gives a more accurate picture of the cash a business generates and it is much harder to fudge. So when I look at dividend cover ratios, I look at them in relation to free cash flow.

April– June 2020 Income

Looking at my portfolios second quarter performance from a purely income standpoint, I didn’t do too badly. My portfolio generated over £860 in dividend income over the quarter. Comparing it to the figure last year where I received £790, it is an increase in £50.


What is amazing is that over the last year, I have not made many purchases with any fresh money. Instead, this £50 increase is a result of organic dividend increases by the companies I am invested in and simple dividend reinvestment.


Two lessons can be drawn from this.


The first is to invest in high quality businesses. The best businesses keep generating profits and keep increasing their dividends irrespective of the economic environment.


And the second is the power of compounding dividends. The power of using your dividends to buy more dividends is amazing. I have written about this topic countless times so I will leave it up to you to search the website and do the reading
Looking at a combined quarter one and quarter two picture, my dividend income is now a tad over £2,000 for the year. That’s £11 a day in pure passive income! And for comparisons sake, at the same point last year, it was only £1,680.


I am slowly but steadily marching my way upwards towards financial freedom

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