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.

Each of these ratios reflect dividends paid in the trailing 12 months; yields are the expected forward yield. Let's examine Caterpillar (NYSE: CAT) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio
Caterpillar

1.7%

16.2

31.3%

55.2%
Deere (NYSE: DE)

2.0%

NA

22.3%

54.6%
Kubota (NYSE: KUB)

1.9%

54.3

32.5%

18.5%
Cummins (NYSE: CMI)

1.5%

37.2

15.3%

98.2%

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

With an interest coverage of 16.2, Caterpillar covers every $1 in interest expenses with more than $16 in operating earnings. Given that its EPS payout ratio and FCF payout ratio are below 55% or so, you shouldn't have to worry that Caterpillar 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.