The term times preferred dividends earned ratio refers to a measure that allows the investor-analyst to understand if the company is generating enough cash to pay its preferred dividends. The times preferred dividends ratio is also of interest to holders of common stock, since preferred shareholders will be paid their dividend before holders of common stock.
Times Preferred Dividends Earned Ratio = Net Income / Preferred Dividend
Capital structure and solvency measures allow the investor-analyst to understand the company's ability to remain in business in the long term. This is usually assessed by examining the relationship between debt, equity and the proportions of different types of stock. Solvency is the ability to continue operating, which oftentimes depends on cash flow. One of the ways to understand the overall solvency position of a company is by calculating their times preferred dividends earned ratio.
The times preferred dividends earned provides the investor-analyst, and holders of preferred stock in particular, with information in terms of the company's historical ability to generate enough profits to pay dividends owed to holders of preferred shares. The metric is found by taking net income and dividing it by preferred dividends. Ideally, this metric will be much greater than 1.0. When preferred dividends are not paid, they are allowed to accumulate. For this reason, a variation of the metric involves taking net income and dividing it by the total preferred dividends owed (including non-payments in prior accounting periods). A value less than 1.0 indicates the company will have trouble making this commitment and may be a financially-stressed business.
The CFO of Company ABC is concerned a downturn in the economy and commensurate decrease in profits may prevent the company from being able to pay dividends owed holders of the company's preferred stock. She asked her team to use the company most recent forecast to calculate times preferred dividends earned ratio. Her team's forecast for net income is $504,000. The company currently has 50,000 shares of preferred stock at $120 offering a 6.5% dividend. The company's times preferred dividends earned is then:
= $504,000 / (50,000 x $120 x 0.65)
= $504,000 / $468,000, or 1.08
Given how close the ratio is to one, the CFO called a meeting of the c-suite executives to discuss the possibility of not being able to pay dividends to shareholders of both preferred and common stock.