As a dividend investor, it pays to follow how much of a company's money goes toward funding its dividend. 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 percent of free cash flow devoted toward paying the dividend. Again, a ratio greater than 80% could be a red flag.

Let's examine Nalco (NYSE: NLC) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

Nalco

0.5%

2.6

6.8%

10.2%

General Electric (NYSE: GE)

3.1%

12.6

41.7%

6.3%

Dow Chemical (NYSE: DOW)

2.8%

2.7

32.4%

93.2%

DuPont (NYSE: DD)

3.2%

7.1

45.9%

NM

Source: Capital IQ, a division of Standard & Poor's. NM = not meaningful due to negative FCF.

With an interest coverage ratio of 2.6, Nalco covers every $1 in interest expenses with $2.60 in operating earnings. Given its EPS payout ratio and FCF payout ratio are around 10%, you shouldn't have to worry that Nalco will need to cut its dividend anytime soon.

Another tool for better investing
Most investors don't keep tabs on their companies. That's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. We can help you keep tabs on your companies with My Watchlist, our free, personalized stock-tracking service.