Are The Dividends Of This 6.1% Yield Safe?

Shares with high dividend yields often attract the attention of income investors. But, it can be a mistake to focus solely on a share’s yield as that figure tells us nothing about what’s important here – how safe the share’s dividends are in the future.

With this in mind, what should investors make of Willas-Array Electronics (Holdings) Ltd (SGX: W12)?

At its current share price of S$0.180, the electronics components distributor has a very attractive dividend yield of 6.1% thanks to its annual dividend of HK$0.0682 per share (around S$0.011) for the financial year ended 31 March 2014 (FY2014).

In comparison, the SPDR STI ETF (SGX: ES3) – an exchange-traded fund which tracks Singapore’s market barometer, the Straits Times Index (SGX: ^STI) – has a yield of just 2.7% at the moment.

Makings of a strong yield

There are a few things I like to look into when I’m trying to determine how safe a company’s future dividends are:

  1. The company’s track record in growing and paying its dividend.

This criterion’s importance lies in the insight it can give investors about management’s commitment to reward shareholders as the business grows.

  1. The company’s ability to grow its free cash flow over time and generate it in excess of the dividends paid.

Ultimately, a company pays its dividends with the cash it has and that cash can from a few sources. A company can 1) take on debt, 2) issue new shares, 3) sell its assets, and/or 4) generate cash from its daily business activities.

There are always exceptions, but it’s generally more sustainable for a company to pay its dividends using the cash it has generated from its businesses.

It thus follows that investors should be keeping a close watch on a company’s free cash flow as it is the cash flow from operations that’s left after the firm has spent the necessary capital needed to maintain its businesses at their current state.

  1. The strength of the company’s balance sheet.

When a company has a weak balance sheet that’s laden with debt, its dividends can be at risk of being reduced or removed – either due to pressure from creditors or from a simple lack of cash – even at the slightest hiccup in the fortunes of its business.

On the other hand, a strong balance sheet that is flush with cash gives a company an ability to tide over the inevitable tough times that rolls along every now and then.

Pulling it all together

The two charts below show how Willas-Array has fared against the three criteria over the past decade:

Willas-Array's dividends and free cash flow

Willas-Array's balance sheet figures

Source: S&P Capital IQ

Let’s have a few quick words about some of the areas of concern that the charts are pointing out to us.

Firstly, Willas-Array has not managed to consistently pay a dividend (there were no dividends in FY2009) for the period under study. In addition, the firm’s track record in producing free cash flow has been all over the place; in the 11 financial years we’re looking at, the company’s free cash flow had been negative in seven of them. Lastly, Willas-Array’s balance sheet has been weak for the most part with the level of borrowings exceeding the amount of cash.

A Fool’s take

Given what we’ve seen (the spotty history with paying a dividend; the inability to consistently produce free cash flow; and the debt-laden balance sheet), it would seem like Willas-Array’s dividends might not be safe.

That being said, it should be noted that this look at Willas-Array’s historical financials is not a holistic overview of the entire picture. Investors should still spend time digging into the qualitative aspects of the firm’s business and consider if brighter days are ahead.

A study of Willas-Array’s financial history can be important and informative, but more work needs to be done beyond that before any investing decision can be made.

For more investing analyses and important updates about the stock market, sign up to The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.