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Warning: Do Not Invest in a Company with Unsustainable Dividend Growth

Last month, a few companies listed in Singapore reported poor results but still managed to increase their dividends paid out to shareholders. Investors who are not familiar with the big picture may be fooled (with a small “f”) into thinking that these companies are performing well, and may be attracted to the greater yield. However, it is important to take note of the reasons behind the dividend increase and whether this growth is sustainable.

Here are two red flags to be aware of when considering dividend growth and sustainability.

Increasing dividend payout ratio

Companies may occasionally increase their dividends, not through higher profits but by increasing their dividend payout ratio. This means they are paying out a higher proportion of their earnings in dividends. This is often to maintain their status as a strong dividend payer and to keep investors trust.

However, a company cannot increase their payout ratio indefinitely. Unless it can increase its profit, this method of increasing dividends is unsustainable in the longer term.

This is especially concerning if the company reported a lower profit for the year, yet continues to increase its dividend paid out. Investors should keep an eye out for these companies, as this type of dividend growth is not sustainable.

Companies that do not have spare cash on their balance sheet

Cash is often dubbed the lifeblood of a company. Looking out for companies that have a sufficient cash is especially important when we are looking at stocks that pay dividends.

Earning trends are unpredictable, and companies may suffer earning setbacks from time to time. Therefore, it is important that companies keep enough cash on their accounts to maintain dividend payouts to investors when any unforeseen scenario affects the company’s bottom line.

A company that has a good cash flow is also vital as it means that it will not have to dig into existing cash reserves to pay off its debt or to run its operations.

The Foolish bottom line

An increasing dividend may feel good to investors but in reality, it may not be the most important aspect for long-term investors. What is more important is the sustainability of the dividend growth and whether it can be maintained even through difficult periods of the business cycle.

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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 contributor Jeremy Chia doesn't own shares in any companies mentioned.