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 Dow Chemical (NYSE: DOW) and three of its peers.



Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

Dow Chemical 2.8% 2.7 32.4% 93.2%
DuPont (NYSE: DD) 3.3% 7.1 45.8% (297.8%)
Monsanto (NYSE: MON) 1.6% 13.1 47.8% 35.6%
PPG Industries (NYSE: PPG) 2.7% 7.7 37.4% 42.0%

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

With an interest coverage of 2.7, Dow Chemical covers every $1 in interest expenses with just under $3 in operating earnings. Although the company's EPS payout ratio is below 35%, its FCF payout ratio is 93.2%. Investors should continue to monitor the FCF payout ratio. If it goes above 100%, the dividend could be in danger of being cut.

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. Motley Fool newsletter services have recommended creating a synthetic long position in Monsanto. 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.