Monday 27 May 2024

Checking the safety of dividend payments

Dividends are an important part of total returns from owning a share.  

Dividends are a cash payment and therefore the company needs to have enough cash flow to make these payments.

Compare the FCF with its dividends

By comparing the free cash flow with its dividends, you can see whether a company has sufficient cash to pay dividends.  

Net cash from operation - CAPEX =  Free Cash Flow

You want to see the free cash flow being the bigger number more often than not.

When dividend is the larger number compared to the free cash flow, this may occur when a company is putting cash to good use (capex).  When dividend  is the larger number is fine on occasional years.  Prolonged periods of insufficient free cash flow will often lead to dividends being cut or scrapped eventually.

When analysing a company, it is often a good idea to compare free cash flow with the dividends over a period of ten years.

FCF dividend cover

A quick way to check whether cash flow is sufficient to pay dividends is by using the free cash flow dividend cover ratio.   This is calculated as follows:

Free Cash Flow dividend cover =  Free cash flow / dividends.

When free cash flow exceeds the dividends by a big margin, it can be a sign that the company may be capable of paying a much bigger dividend in the future.

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