Dividend investors know that it pays to follow how much of a company's money goes toward funding its payouts. A nice yield now won't matter much if the company can't keep making those payments going forward.

Here, we'll highlight a given company and its closest competitors to see just how safe their dividends are, with a little help from three crucial tools:

  • The interest coverage ratio, or earnings before interest and taxes, divided by interest expense. The interest coverage ratio measures a company's ability to pay the interest on its debt. An interest coverage ratio less than 1.5 is questionable; a number less than 1 means that the company is not bringing in enough money to cover its interest expenses.
  • The EPS payout ratio, or dividends per share divided by earnings per share. The EPS payout ratio measures the percentage of earnings that go toward paying the dividend. A ratio greater than 80% is worrisome.
  • The FCF payout ratio, or dividends per share divided by free cash flow per share. Earnings alone don't always paint a complete picture of a business' health. The FCF payout ratio measures the percentage of free cash flow devoted toward paying the dividend. Again, a ratio greater 80% could be a red flag.

Let's examine CVS Caremark (NYSE: CVS) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

CVS Caremark 1.3% 11.1 15.7% 13.7%
Walgreen (NYSE: WAG) 1.6% 45.3 28.1% 24.3%
Wal-Mart Stores (NYSE: WMT) 2.6% 11.4 31.9% 55.5%
Omnicare (NYSE: OCR) 0.4% 2.9 (10.8%) 3.5%

Source: Capital IQ, a division of Standard & Poor's.

With an interest coverage of 11.1, CVS covers every $1 in interest expenses with $11.10 in operating earnings. Given that its EPS payout ratio and FCF payout ratio are below 20%, you shouldn't have to worry that CVS will need to cut its dividend anytime soon.

Another tool for better investing
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Follow Dan Dzombak on Twitter at @DanDzombak to check out his musings and see what articles he finds interesting. The Motley Fool owns shares of Wal-Mart. Motley Fool newsletter services have recommended Wal-Mart, as well as a diagonal call position in Wal-Mart. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.