Dividend Safe? Free Cash Flow Test Na Here

Is dividend safe? The most direct test na cash test: take operating cash flow wey company report, subtract capital spending wey e need to keep business running, then compare wetin remain with the cash wey e actually pay out. That ratio — dividends paid as a share of free cash flow — answer different question from yield. Our dividend yield trap guide start from price and ask why yield high reach that level. This page start from cash flow statement and ask whether the money behind the payout ever dey there.

Wetin follow na framework for how to read filing, no be prediction about any company. Boards dey declare dividends one quarter at a time. Dem fit raise, hold, cut, or suspend am for any meeting, no matter wetin the arithmetic show.

How you calculate free cash flow dividend coverage?

Every input dey on one page of 10-K or 10-Q: consolidated statement of cash flows. Four lines matter.

• Net cash provided by operating activities, the subtotal wey close the first section.
• Purchases of property, plant and equipment, usually labeled capital expenditures. E dey for investing section and dem print am as negative.
• Dividends paid. E dey for financing section and e too be negative.
• Dividends paid to noncontrolling interests, where company report am separately. That cash still comot, and none of am belong to common holders.

Free cash flow na operating cash flow minus capital expenditures. Coverage na dividends paid divided by free cash flow, read as percentage. Under 100% mean say payout fit inside the cash wey business generate. Over 100% mean say e no fit, and the shortfall come from cash balance, new borrowing, asset sale, or equity raise. Some desks invert the ratio and quote multiple: free cash flow over dividends, where 1.0x mark the same break-even line.

Why payout ratio fit look fine on EPS but fail on cash?

The familiar EPS payout ratio divide dividends per share by earnings per share. Earnings na accrual measure, and accruals fit separate from cash for normal ways.

Take hypothetical manufacturer. E report $400 million net income, add back $200 million depreciation, and show $600 million net cash from operating activities. E spend $450 million on capital expenditures and pay $320 million dividends. EPS payout ratio na $320m over $400m: 80%, comfortably inside the line. Free cash flow na $600m minus $450m, or $150 million, and the same dividend na 213% of am. Na one company, one year, two ratios wey disagree by factor of two and a half.

Both panels below dey use those invented figures, entered as constants for the SQL instead of lifted from any filing.

SELECT
    cash_flow_line,
    usd_millions
FROM
(
    SELECT 'Net income' AS cash_flow_line, 400 AS usd_millions, 1 AS line_order
    UNION ALL
    SELECT 'Depreciation add-back', 200, 2
    UNION ALL
    SELECT 'Net cash from operating activities', 600, 3
    UNION ALL
    SELECT 'Capital expenditures', -450, 4
    UNION ALL
    SELECT 'Free cash flow', 600 - 450, 5
    UNION ALL
    SELECT 'Dividends paid', -320, 6
)
ORDER BY line_order

SELECT
    ratio_basis,
    ROUND(100.0 * dividends_usd_mm / denominator_usd_mm) AS payout_pct
FROM
(
    SELECT 'Dividends over net income' AS ratio_basis, 320 AS dividends_usd_mm, 400 AS denominator_usd_mm, 1 AS ratio_order
    UNION ALL
    SELECT 'Dividends over free cash flow', 320, 600 - 450, 2
)
ORDER BY ratio_order

The first panel na one column from statement of cash flows, read from top to bottom. The second divide the same $320 million by two different denominators and get two answers for opposite sides of the line.

The wedge na the $250 million between wetin company spend on capital and wetin e charge as depreciation. Depreciation dey booked against earnings at historical cost of assets wey company buy years ago. Replacement happen with cash at today’s prices. Income statement no dey show that gap.

Other accruals push for the same direction. Build-up in receivables or inventory na cash out, but e no affect reported net income. Stock based compensation dey added back inside operating cash flow as non-cash expense, while the cost land on existing holders as dilution instead. Non-cash impairments push the other way: goodwill write-down fit drive EPS payout ratio past 100% for quarter where not one dollar of operating cash move. For REITs, the gap dey structural instead of occasional because property depreciation dominate income statement. Industry convention dey covered for our REIT payout ratio on FFO guide.

Wetin else you fit check for filings?

One coverage number na snapshot. Four second-order checks turn am into full picture, and each one come from document wey reader fit open.

Eight quarters, no be one year. Cash flow statements for 10-Q dey cumulative year to date, so Q3 filing show nine months instead of three. To isolate one quarter, subtract prior quarter’s year-to-date figure from current one. Q4 na annual 10-K total minus the nine-month figure. When you line up eight quarters, you fit separate coverage ratio wey dey move steadily one direction from one wey dey bounce around seasonal pattern.

Debt maturities and interest coverage. Long-term debt footnote list principal wey due over the next five years. Operating income divided by interest expense give rough interest coverage ratio. Payout wey barely clear free cash flow, for year wey large maturity dey land, dey compete with refinancing for the same dollars.

Buybacks. Repurchases of common stock dey one or two lines near dividends paid for financing section. Add both and divide by free cash flow to get total shareholder payout. Company wey dey 70% on dividends and 130% on dividends plus buybacks get lever wey e fit pull before e touch dividend. Paused buyback program no carry the same weight as a cut.

Asset sales. Proceeds from divestitures and property disposals dey for investing section. Cash from sale fit fund payout only once. A run of disposals alongside coverage above 100% deserve reading as one story.

Two dividend cuts, read from the cash flow statement

Neither example na forecast. Both na finished history.

General Electric, 2017 and 2018. GE cut quarterly common dividend from 24 cents per share to 12 cents on November 13, 2017. Then e cut am from 12 cents to 1 cent on December 7, 2018, according to company announcements for those dates. For the years before that, common dividend reach roughly $8 billion yearly, above the industrial free cash flow wey GE itself report and guide to for the same period. The difference come from cash wey move up from GE Capital and divestiture proceeds. Both show for investing and financing sections well before November 2017. Na the kind pattern wey coverage test dey designed to expose: operating business dey distribute more cash than e generate, while sources wey no repeat dey fill the gap.

Kraft Heinz, February 2019. Kraft Heinz reduce quarterly dividend from 62.5 cents per share to 40 cents on February 21, 2019. Company announce am with fourth-quarter 2018 results, wey carry $15.4 billion non-cash impairment of goodwill and intangible assets. The impairment move EPS violently but e no move operating cash flow at all. Na the exact disagreement wey we describe above. Reader wey use EPS payout ratio dey hold number wey lose meaning for that quarter. Reader wey use cash see operating engine attached to balance sheet wey carry merger-era leverage, while company publicly commit to reduce am.

When you read enough examples, the pattern dey repeat: coverage above 100% across several quarters, financing section dey depend on new borrowing, investing section dey depend on disposals, and deleveraging commitment dey inside the same document as dividend. Our guide to dividend cuts cover the mechanics of the announcement itself. A single-company page like Verizon's dividend history show how declaration record dey look over time.

None of that na prediction, and no ratio be prediction. Board with under-covered dividend fit close the gap by reducing capex, selling division, or carrying more leverage for one year, and many companies don do am. The test tell you where cash come from. The next board meeting na separate event.

FAQ

Wetin be good free cash flow payout ratio?

No official threshold dey. Under 100% mean say dividend fit inside the cash wey business generate after capital spending. The further below the line, the more room company get to absorb weak year. Capital-light businesses dey far below the line, while capital-heavy ones dey close to am. So the useful comparison na against company’s own history and direct competitors.

Company fit pay dividend when free cash flow negative?

Yes, and some companies dey do am for years. The cash fit come from balance sheet, new borrowing, or asset sales. All of dem dey show for investing and financing sections of the same statement. E go continue as long as those sources last.

Dividends paid na the same as dividends declared?

No. Declared na board commitment, recorded for equity statement and dividend footnote. Paid na cash wey actually comot during the period, recorded for financing. If period end fall between declaration date and payment date, the two fit no match. That one normal.

Free cash flow test work for REITs and banks?

No be as e dey written here. REIT earnings and cash flow both dey distorted by property depreciation, and the sector use FFO and AFFO instead. Banks no get meaningful capex line and dem dey assess am with regulatory capital. So industrial coverage ratio go misread both.

Where the numbers for the two panels come from?

Dem na constants wey dem write inside SQL, for teaching example instead of any company’s reported results. Open the SQL under either panel and you go see the whole arithmetic: six lines for the first one, one division for each line of the second.

The whole framework dey run on four lines from one statement, and the work na to line up those lines across eight quarters. Strasmore terminal dey pull dem for ticker and stack dem period by period.