Not all dividends are created equal. Here, we'll do a top-to-bottom analysis of a given company to understand the quality of its dividend and how that's changed over the past five years.

The company we're looking at today is Walter Energy (NYSE: WLT), which yields 0.7%.

Industry
Walter Energy is a producer of met coal for the steel industry. The company -- along with competitors Patriot Coal (NYSE: PCX) and Alpha Natural Resources (NYSE: ANR) -- have been hurt as customers have slowed down orders of coal. Walter's stock price has jumped around lately as some U.K. newspapers have speculated that BHP Billiton (NYSE: BHP) was considering acquiring the company.

Walter Energy Total Return Price Chart by YCharts.

Dividend
To evaluate the quality of a dividend, the first thing to consider is whether the company has paid a dividend consistently over the past five years, and, if so, how much has it grown.

Walter Energy Dividend Chart by YCharts.

Walter Energy's dividend has sharply and steadily risen since 2008, and is now $0.13 per quarter.

Immediate safety
To understand how safe a dividend is, we use three crucial tools, the first of which is:

  • The interest coverage ratio, or the number of times interest is earned, which is calculated by 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. A ratio less than 1.5 is questionable; a number less than 1 means the company is not bringing in enough money to cover its interest expenses.

Walter Energy Times Interest Earned TTM Chart by YCharts.

At 8.41, Walter Energy covers every $1 in interest expense with more than $8 in operating earnings.

Sustainability
The other tools we use to evaluate how safe a dividend is are:

  • 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's 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.

Source: S&P Capital IQ.

Walter Energy's payout ratio has been consistently below 20%.

Alternatives

Source: S&P Capital IQ.

With a low yield, there are alternatives in the industry. Alliance Resource Partners (Nasdaq: ARLP) has a 5.3% yield and nearly a 50% payout ratio. Arch Coal (NYSE: ACI) has a yield nearly four times higher than Walter Energy's at 2.8% and a payout ratio of just double. Cliffs Natural Resources (NYSE: CLF) rounds out the group with a dividend yield of 1.6% and a payout ratio of just 6%.

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.

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 buying shares of Alliance Resource Partners and Walter Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.