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.

Each of these ratios reflects dividends paid in the trailing 12 months, while yields are the expected forward yield. Let's examine Eaton (NYSE: ETN) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

Eaton

2.6%

10.1

37.7%

77.2%

Rockwell Automation (NYSE: ROK)

2.0%

12.6

34.3%

93.1%

Emerson Electric (NYSE: EMR)

2.5%

14.4

43.7%

48.5%

General Electric (NYSE: GE)

3.3%

10.6

41.7%

6.5%

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

With an interest coverage of 10.1, Eaton covers every $1 in interest expenses with just over $10 in operating earnings. While the company's EPS payout ratio is below 40%, its FCF payout ratio is a worrisome 77%. While the company won't have a problem paying its dividend, should this number rise, take heed.

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.