Dividend Coverage Ratios: How Safe is Your Dividend?

by | Investment Analysis

Dividend Coverage Ratios allow analysts to evaluate the safety of a company’s dividend. Many investors concentrate on the dividend yield but don’t give sufficient attention to the safety of that dividend.

In the long run companies must create enough cash flow to pay expenses, invest in the future (capital expenditures), service their debt (if any), and return money to shareholders.

Our Dividend Analyzer Safety Score is made up of four key metrics:

Net Financial Debt / Total Assets
Piotroski F-Score
CFO Dividend Coverage Ratio
FCF Dividend Coverage Ratio

Together these four metrics provide a fairly comprehensive analysis of the long and short term safety of a company’s dividend. Net Financial Debt / Total Assets is my absolute favorite dividend safety metric for evaluating the long term financial condition of a company. The other three metrics (Piotroski F-Score is actually 9 metrics) provide insight into the current condition of company operations.

The following Dividend Coverage Ratios are metrics every investor should become familiar with. I have already dealt with Dividend Payout Ratios in another post so this post will provide a quick review with links and provide an in-depth review of the CFO & FCF Dividend Coverage Ratios:

Dividend Payout Ratios

The Dividend Payout Ratio tells you how much of the company’s accounting profits are being given back to shareholders in the form of dividends. This is the most often used and quoted ratio.

The Cash Dividend Payout Ratio provides a much better analysis of the safety and ability of a company to carry on its business AND pay its dividend. Why?

First of all, starting with Cash Flow from Operations means that you have a number that can’t be manipulated as net income often is. This is the actual cash generated from the operations of the business. Where do dividends come from? Cash; not some number contrived from lots of accounting rules (net income).

CFO Dividend Coverage Ratio

The CFO Dividend Coverage Ratio is a simpler and cleaner version of the Cash Dividend Payout Ratio. It uses the Cash Flow From Operations (Cash Flow Statement) and compares it to the current dividends being paid.

However, as usual, when something is simpler or more basic, it doesn’t provide as much information. The CFO Ratio does not take into account capital expenditures. The FCF Ratio and the Cash Dividend Payout Ratio do.

CFO Dividend Coverage Ratio Calculation

CFO Dividend Coverage Ratio = Cash Flow From Operations (CFO) / Total Dividends Paid

or

CFO Dividend Coverage Ratio = Cash Flow From Operation per share / Dividends Per Share

This metric tells you whether the company is creating enough cash flow from its core business operations to support the dividend. This is important. We can take capital expenditures into account in the next ratio. I want to know how much cash the company operations is generating compared to the dividend.

A ratio of 4.0 or more is considered good. That would mean the company is creating 4 times as much Cash From Operations as required to pay the dividend. Of course the higher the ratio the greater your margin of safety.

Anything below 2.0 is a red flag in my opinion. That would indicate the company has less than twice the cash from operations to pay it’s dividend. Don’t forget the company has to invest in the future (capital expenditures), and pay off debt (in the long run) too. You don’t want all the company’s CFO going to the dividend.

A ratio below 1.0 would mean the company is not producing enough cash to even pay the dividend. That would definitely indicate the dividend was in jeopardy of being reduced or cut because the company would have to use other resources to pay the dividend.

Free Cash Flow (FCF) Dividend Coverage Ratio

The Free Cash Flow (FCF) Dividend Coverage Ratio is similar to the CFO Dividend Coverage Ratio; the difference being it takes into account company capital expenditures too. In other words free cash flow is the cash from operations (cash flow statement) less capital expenditures.

Free Cash Flow = Cash Flow From Operations (CFO) – Capital Expenditures

FCF Dividend Coverage Ratio Calculation

FCF Dividend Coverage Ratio = Free Cash Flow / Common Stock Dividends

or

FCF Dividend Coverage Ratio = Free Cash Flow Per Share / Dividends Per Share

This metric provides the ratio between the dividend and the cash flow from operation minus capital expenditures. In other words, how much cash is left from operations after capital expenditures are made. This number is then compared to the dividend.

A ratio above 2.5 is probably good. That would mean the company has an adequate margin of safety for sustaining its dividend because it is creating 2 1/2 times as much free cash flow needed to pay its dividend.

A ratio of less than 1.4 is a red flag in my opinion. This would indicate the company has little margin of safety to pay the dividend after paying its expense and capital expenditures.

A ratio below 1.0 would indicate the company was having to find other resources (savings, borrowing, etc.) in order to pay the dividend. That would indicate the dividend was in jeopardy of being reduced or cut because the company would have to use other resources to pay the dividend.

Those of you who are astute analysts may realize this ratio is similar to the Cash Dividend Payout Ratio. There are are two small differences. First the payout ratio subtracts capital expenditure AND preferred stock dividends from cash flow. Second the numerator and denominator are reversed.

For Review:

Cash Dividend Payout Ratio = Common Stock Dividends / (Free Cash Flow – Preferred Dividend Paid)

FCF Dividend Coverage Ratio = Free Cash Flow / Common Stock Dividends

Therefore, unless a company has preferred stock dividends both of these metrics provide the same information.

I hope you’ll take the time to explore all the important metrics we use in the Dividend Analyzer. Here you will find a short review of each metric with a link for further research on each one.

Additional Reading:
Apple (AAPL) Dividend Stock Analysis
Dividend Kings List (50+ Years of Consecutive Dividend Increases)
ETF Portfolio Newsletters

Value Investing Portfolio Management Guides

Arbor ETF Portfolios Newsletter:  ETF Conservative Portfolio, ETF Dividend & Income, &  ETF Aggressive Portfolio

Dividend Value Builder - DVB Analyzer Newsletter & DVB Portfolio Newsletter

AAAMP Value Newsletter - Global Deep Value Asset Allocation Portfolio

Learn More

Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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