Worksheet: Dividends vs debt service
Can a company afford the dividends it is paying?
This note is part of the Pier Review reference material.
Previous worksheet: Growth rate. Next sheet: Debt cover
Dividend yield can mislead
After the P/E ratio, the most commonly cited financial metric cited in the financial columns is a company's dividend yield. If it's high, that's considered an attractive thing, though occasionally journals correctly warn readers that yields that are notably high are often so because markets believe that the business can't maintain its historic level of dividend payouts, and have marked down the share price in the expectation that the dividend will soon too be heading south.
Because Pier Analysis concentrates on a company's cash flow, subscribers to Pier Review can assess for themselves whether companies' dividend policies are sustainable, or whether they have succumbed to perceived pressure from financial markets to pay dividends that they can't really afford.
By can't afford, we mean that they pay out amounts that exceed what they have generated by way of enterprise cash flow. There's are three ways to do that
spend cash built up in previous years: eventually it will run out
borrow the money: that too isn’t sustainable
raise fresh equity and pay dividends out of it: that amounts to paying shareholders with their own money.
Pier Analysis seeks to bring to the assessment of companies the mindset of investors in infrastructure, who would never do any of these things.
Paying investors with their own money
The purpose of the dividend versus debt service schedule is to work out to what extent, if any, a business is borrowing to make its dividend payments. It does so by showing lines that are also to be found on the direct cash flow, but presenting them in a different order.
On the direct cash flow, the sequencing of the debt and equity items is intended to show the priority with which their providers have call on the enterprise cash flow generated by the company: lenders first, then investors.
On the dividends vs debt service worksheet, the order is slightly changed: enterprise cash flow is applied first to any obligation to pay interest, then to the whatever level of dividends are showed as paid in the accounts. What's left is what could be used to repay any debt.
If the amount available to repay debt is negative, it's a sign that the company has had to borrow, or raid cash reserves, or tap shareholders to achieve its dividend payment.
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Previous worksheet: Growth rate. Next sheet: Debt cover