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Worried about your dividends? Here's how to check how safe they are…

by , 11 August 2015

If you're investing for income, one of the main reasons for buying a particular share is whether it has a history of paying dividends and increasing that pay out over time.

By investing in shares, you also hope a company's share price will rise over time.

So how can you check if a company is going to continue paying dividends?

Read on to find out…

Companies that pay dividends

If a company you invest in for income cuts its dividend, it’s going to have a negative impact on its share price. When companies start to reduce their dividends, their share price tends to fall.

You don’t want this to happen to you, whether you’re investing for dividends or for share price appreciation.

Here’s how you can check whether a company will keep paying dividends…

How to check a company can afford to pay dividends

Look at a company’s cash flow in its financial statements, Marc Lichtenfeld in Investment U explains.

Focus on:

  • A company’s cash flow from operations;
  • Its capital expenditures; and
  • Its dividends paid.

A company’s cash flow from operations tells you how much it generates from its business on a day-to-day basis. On the other hand, capital expenditures covers the cash a company spends on equipment and similar things.

From these two figures you can calculate a company’s free cash flow:

Free cash flow = Cash flow from operations – capital expenditures

Compare the free cash flow figure with the amount of money the company paid out in dividends.

You want to see higher free cash flow. If it’s not, the company doesn’t make enough cash to sustain paying its dividend. In this case, a company will have to borrow money or sell shares in order to keep paying its dividends.

Ideally you’re looking for dividends paid to be no more than 75% of a company’s free cash flow. This gives a company plenty of breathing room.

So there you have it. How to check how safe a company’s dividends are.

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Worried about your dividends? Here's how to check how safe they are…
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