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 80% could be a red flag.

Let's examine 3M (NYSE: MMM) and three of its peers. The company has been doing well, but some analysts are worried about 3M's cash conversion cycle.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

3M 2.4% 30.9 36.5% 53.8%
General Electric (NYSE: GE) 3.3% 10.6 41.7% 6.5%
Emerson Electric (NYSE: EMR) 2.7% 14.4 43.8% 48.5%
Ingersoll-Rand (NYSE: IR) 1% 4.9 17.1% 134.1%

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

With an interest coverage of 30.9, 3M covers every $1 in interest expenses with more than $31 in operating earnings. And given its EPS payout ratio and FCF payout ratio below 55%, you shouldn't have to worry that 3M 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 MyWatchlist, our free, personalized stock-tracking service.

Follow Dan Dzombak on Twitter at @DanDzombak to check out his musings and see what articles he finds interesting.

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