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 Rockwell Collins (NYSE: COL) and three of its peers.



Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

Rockwell Collins 1.6% 44.1 25.6% 55.5%
Raytheon (NYSE: RTN) 3.5% 18.3 33.1% 35%
L-3 Communications (NYSE: LLL) 2.1% 6.5 20% 21.8%
General Dynamics (NYSE: GD) 2.5% 25.4 25% 22.8%

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

With an interest coverage ratio of 44.1, Cliffs covers every $1 in interest expenses with $44 in operating earnings. Given its EPS payout ratio and FCF payout ratios are below 60%, you shouldn't have to worry that Rockwell Collins 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. The Motley Fool owns shares of L-3 Communications Holdings, General Dynamics, and Raytheon. Motley Fool newsletter services have recommended L-3 Communications Holdings. 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.