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 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 Xerox (NYSE: XRX) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

Xerox 2.1% 5.6 5.7% 14.6%
International Business Machines (NYSE: IBM) 1.6% 54.4 22.1% 26.9%
Hewlett-Packard (NYSE: HPQ) 1.9% 22.5 8.5% 13.7%
Pitney Bowes (NYSE: PBI) 7.2% 7.1 88.8% 34.5%

Source: S&P Capital IQ.

With an interest coverage of 5.6, Xerox covers every $1 in interest expenses with almost $6 in operating earnings. Given its EPS payout ratio and FCF payout ratio are below 15%, you shouldn't have to worry that Xerox 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.