How safe is your dividend?

Many purists and academics argue that dividends don't matter. They say that the value of a company does not depend on the size of its dividend and that in fact a company that pays no dividend can be worth more than one that does.

In lots of ways these people are right. But in practical terms, dividends do matter. With very low interest rates, dividends have become an important source of income for many people. And the annual dividend declared by a firm can also act as a signal to investors about the company's prospects.

You only have to look at how share prices of companies often tumble when a dividend is cut to see how important they are. This happens because the decision to cut the dividend often takes people by surprise.

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But should it? By knowing what to look for, there are ways you can spot a dividend that is under threat. I'll show you how.

Dividend cover

This is the most frequently used test of how safe a dividend is how many times a company's after-tax profits cover the annual dividend payment. It is calculated by dividing the earnings per share (EPS) by the dividend per share (DPS).

So, if a company has EPS of 50p and DPS of 25p, the dividend is covered twice. You'd think your payment is fairly safe with that level of cover.

The trouble is that 50p of EPS mightnot be sustainable if a company's profits go up and down with the health of the economy. Try to look at the average profits of a company over a ten-year period to see if the 25p dividend could be comfortably paid in good times and bad. What's more, you can't always trust profit numbers.

A far better measure of dividend cover is based on a company's free cash flow how much money it has left over after all the bills have been paid. Cash flow can differ from profit depending on when a company pays its suppliers, gets paid by its customers and how much money it has to invest in the business.

If a company's free cash flow per share does not cover its dividend per share, the company is effectively borrowing to pay the dividend. That can't go on forever.

Dividend history

This is a very simple test. Have a look back at a company's dividend record. If it has had to reduce its dividend in the past when times have got tough, then there's a good chance that it may have to reduce it again in the future.

House builders and construction companies are good examples of this. A dividend that has stayed the same for years is also a warning sign, as it is vulnerable to a cut if profits fall.

A declining ROCE

ROCE (return on capital employed) is by far the best measure of a company's profitability. It looks at what return a company is getting on the money it invests. High returns are a sign of a strong company.

A declining ROCE is a worrying sign of a business that is getting weaker. Dividends may be maintained by investing more money (just like putting more money in a savings account) at a lower rate of return, but eventually a company runs out of funds to do this. When this happens the dividend is often cut.

Too much debt

Debt is one of the biggest threats to a dividend. Unlike a dividend, paying the interest on borrowings is not optional. The more debt there is the more interest that needs to be paid which means less money for shareholders, especially if trading takes a turn for the worse.

Look out for forms of hidden debt, such as rental commitments for buildings and equipment, or a big hole in a pension fund that needs plugging. These are claims on a company's cash flow that rank in front of any dividend payment.

An underinvested business

A company can boost profits and cash flow by not replacing assets when they wear out and letting them age. There is a way of spotting this.

You can find the approximate age of a company's assets by digging in the notes of its accounts and dividing the accumulated depreciation of its assets by the annual depreciation charge. An ageing asset base, or one that is much older than its peers, is a red flag that needs to be investigated.

The red flags in Tesco's accounts

Although Tesco's dividend had increased over the last ten years and looked to be comfortably covered by profits, there were lots of warning signs that all was not well. Firstly, profits have been falling while the dividend has barely increased at all during the last five years.

It also wasn't covered by free cash flow. ROCE has fallen by more than 3% and debt has soared. The age of Tesco's assets has also increased, which may explain why some of its stores are looking a little tired and customers have

gone elsewhere.