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

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

Medtronic

2.9%

11.0

32.1%

31.6%

Johnson & Johnson (NYSE: JNJ)

3.6%

29.6

54.1%

N/A

Abbott Laboratories (NYSE: ABT)

3.6%

14.0

64.8%

N/A

Pfizer (NYSE: PFE)

4.2%

9.7

71%

34.4%

Source: S&P Capital IQ. N/A = not available.

With an interest coverage of 11, Medtronic covers every $1 in interest expenses with $11 in operating earnings. Given that its EPS payout ratio and FCF payout ratio are below 35%, you shouldn't have to worry that Medtronic will need to cut its dividend anytime soon.

Another tool for better investing
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Follow Dan Dzombak on his Twitter account, @DanDzombak, to check out his musings and see what articles he finds interesting. He owns no shares of the companies mentioned. The Motley Fool owns shares of Medtronic, Johnson & Johnson, and Abbott Laboratories. Motley Fool newsletter services have recommended buying shares of Pfizer, Johnson & Johnson, and Abbott Laboratories. Motley Fool newsletter services have recommended creating a diagonal call position in Johnson & Johnson. 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.