2 Important Things You Must Study When It Comes To Dividends

Credit: Simon Cunningham

I think it’s fair to say that many investors love dividends and high-yielding stocks. After all, wouldn’t it be wonderful to see fat dividend checks being mailed to you periodically? But the thing is, it can be a danger to invest based on a share’s yield alone.

That’s because the yield figure tells us nothing about what’s really important – the company’s ability to maintain or raise its dividends in the future. What can help give us some insight here would be a study of the company’s fundamentals – more specifically, its cash flows and balance sheet.

Cash (flow) is king

A few years ago, my U.S. colleague Brian Richards had wrote an article about his experience with an old investment of his in the company Brown Shoe.

Prior to 1995, Brown Shoe had either grown or kept its dividend steady for the past 20 years. But all that changed in the third quarter of that year, when Brown Shoe’s dividend was hacked by 37.5%. Brian had quoted the company’s reasons for its decision and it is reproduced below:

“The dividend had been increased or maintained for 20 years, and over the years had contributed very substantially to shareholder returns. But in recent years the dividend has principally been supported by cash flow from structural change — business sale or liquidation and plant closings.

The conclusion of these structural changes, difficult retail business and pressure on operating earnings in 1995 which was expected to continue into 1996, and the continuing high priority of protecting the balance sheet and our capability to finance the operation of the company, collectively made necessary the lower dividend.”

Dividends are ultimately paid using cash and without adequate cash flow from normal business operations, a company’s dividends may be at risk of being cut or even removed entirely – Brown Shoe’s experience serves as a reminder for this point.

A healthy financial condition is a must

I’ve mentioned earlier that the balance sheet is another important consideration for investors when it comes to assessing a company’s merits as a dividend stock. London-listed mining giant Glencore PLC is a great example of the risks that a weak balance sheet can pose.

Since its listing in 2011, Glencore’s balance sheet has carried plenty of borrowinngs, as alluded to by the high net-debt (total debt minus cash and short-term investments) to equity ratios of at least 80%. You can see this in the chart below:

Glencore's net-debt to equity ratio
Source: S&P Capital IQ

With a giant slump in commodity prices taking place over the past few years, Glencore’s business had been hurt and it announced in September 2015 that it had to take on a slew of drastic measures – including completely eliminating its dividends – in order to conserve cash and shore up its balance sheet.

A strong balance sheet – one that isn’t heavily saddled with debt – gives a company higher odds of protecting its dividends even during times when its business environment turns sour. A weak balance sheet reduces the odds.

A Fool’s take

To be clear, a study of a company’s cash flows and balance sheet are not the only things that matter when it comes to investing for dividends. But, they are still very useful.

At the moment, there are a number of blue chips – the 30 stocks that make up the Straits Times Index (SGX: ^STI) – which have high dividend yields of more than 5% based on their current share prices and dividends for their last-completed fiscal years. Some examples are Keppel Corporation Limited (SGX: BN4), Sembcorp Industries Limited  (SGX: U96), and StarHub Ltd  (SGX: CC3); the trio have yields of 7.1%, 6.7%, and 5.9% at the moment.

Investors who are attracted to them by virtue of their high yields may want to spend some time digging into their cash flows and balance sheets. Doing so may give the investor better insight into the trio’s investing merits.

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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 companies mentioned.