Why you need to look at a company's cash before investing for dividends

by , 12 August 2015

If you're an income seeker, you're looking to invest in companies paying out solid dividends.

You don't want to invest in a company for its dividends, only for it to cut or suspend its dividend payment entirely.

So how can you increase the odds of buying a solid dividend payer?

Read on to find out…

How to work out a company’s cash flow

Looking at how much spare cash a company has is one of the best ways to determine whether a company can keep paying dividends.

To calculate a company’s free cash flow, you need to look at its cash flow statement and take note of these three figures:

  • Cash flow from operations;
  • Capital expenditures; and
  • Dividends paid.

Minus capital expenditures from cash flow from operations to get a company’s free cash flow. Then compare this to the dividends paid. You want to see more money in a company’s free cash flow than its dividends paid.

Let’s take a look at an example…

The impact of free cash flow on dividends

Company ABC has R20 million in cash flow from operations. It has R10 million in capital expenditures. This gives it free cash flow of R10 million.

If Company ABC paid out R5 million in dividends, that’s only 50% of its free cash flow.

But if Company ABC paid out R12.5 million in dividends, that’s 125% of its free cash flow. This means the company would have had to find an addition R2.5 million to pay its shareholders because it didn’t generate enough cash itself.

You shouldn’t use this method to check some companies’ dividends, like real estate investment trusts (REITs) and banks.

But in most instances, using free cash flow is a great way to check if a company is going to continue to pay its dividends.

So there you have it. Why you need to look at a company’s cash before investing for dividends.

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Why you need to look at a company's cash before investing for dividends
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