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'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.

Each of these ratios reflect dividends paid in the trailing 12 months, while yields are the expected forward yield. Let's examine L-3 Communications (NYSE: LLL) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

L-3 Communications

2.6%

6.7

19.9%

22.4%

Lockheed Martin (NYSE: LMT)

5.1%

11.5

8.8%

39.5%

Northrop Grumman (NYSE: NOC)

3.5%

14.0

7.0%

24.3%

United Technologies (NYSE: UTX)

2.6%

12.3

34%

29.7%

Source: S&P Capital IQ.

With an interest coverage of 6.7, L-3 Communications covers every $1 in interest expenses with almost $7 in operating earnings. Given its EPS payout ratio and FCF payout ratio are below 25%, you shouldn't have to worry that L-3 Communications 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.