Dividend cuts can surprise investors, even the big players. But that doesn't mean it's impossible to know ahead of time whether your dividend is at risk of being reduced. There are several factors that can indicate how safe your dividend income is.

Unlike safe investments such as bank deposits or Treasury bonds, dividends are not guaranteed. If a company runs into a cash crunch, cutting or eliminating dividend payment is one way it can try to save itself, but such action can send the wrong signals to the market. Even safe-haven companies can become dividend investment sinkholes.
Consider the U.S. telecom AT&T. Long regarded as a stable business with seemingly risk-immune dividends, AT&T shocked investors in Dec 2000 when it slashed its dividend by 83%. Shareholders expecting to receive $0.22/share each quarter were forced to accept just $0.0375/share.

Looking back at AT&T's financial statements, let's go over some of the points to consider when sizing up dividend risk.

Earnings Trends and Payout Ratio Watch out for inconsistent or declining profitability. If a company can't make a steady profit, it may not stick to its dividend payouts.

In the late 1990s, AT&T started to feel squeezed as deregulation opened up the telecom industry to new entrants, severely impacting its bottom line. If you look at AT&T's income statements in the run-up to Dec 2000 dividend cut, it's hard to miss the dramatic erosion in AT&T's earnings between 1998 and 2000. Annual earnings per share fell by more than 50% in the period. 

To find the figures yourself, go to http://www.att.com/, and in the 'Investor Relations' section look at its 10-K (annual) reports, which are statements filed with the Securities and Exchange Commission (SEC) giving a comprehensive overview of the company's financial position. In AT&T's 10-K for the year ended Dec 2000, you can find AT&T common stock group earnings on its Consolidated Statement of Income. AT&T's annual basic earnings per share from 1998-2000 was $1.96, $1.74 and $0.88. (For most companies, you can find frequent and up-to-date earnings information in quarterly 10-Q reports, which are filed with the SEC and normally published on company websites.)

Falling profits like those faced by AT&T between 1998 and 2000 are not likely to cover the cost of paying the dividend. A good indicator of whether falling earnings pose a risk to dividend payments is the dividend payout ratio, which simply measures how much of a company's earnings are paid to shareholders in the form of dividends. The dividend payout ratio is calculated by dividing a company's dividends by its earnings:

 Dividend Payout Ratio = Dividend Payment per Share / Earnings per Share

Examining AT&T's 10-Q (quarterly) report for the quarter ended Sept 2000 (the last report before AT&T announced its dividend cut), you will see from the Consolidated Statement of Income for the quarter that AT&T earned $0.35 per share and offered a quarterly dividend of $0.22/share, giving it a payout ratio of 0.63. In other words, AT&T was paying out 63% of its earnings in the form of dividends. Significant earnings erosion pushes the payout ratio closer to 1, which means the dividend is claiming almost all of the company's earnings. When earnings are not sufficient to cover dividends, a ratio of 1 is a signal that a dividend cut could be on the way. 

Cash Flows Dividends are paid from a company's cash flow. Free cash flow (FCF) tells investors the actual amount of cash a company has left from its operations to pay for dividends, among other things, after paying for other items such as salaries, research and development and marketing. 

To calculate FCF, make a beeline for the AT&T's cash flow statement. Again, you can find an annual cash flow statement in the 10-K document and quarterly cash flows in the 10-Q reports. Take a look at AT&T's Consolidated Statement of Cash Flows for the year to Dec 2000, found in its 10-K. AT&T's net cash flow provided by operating activities (operating cash flow) totaled $13.3 billion. From this number subtract $15.5 billion, the capital expenditure required for current operations, which is shown lower down on AT&T's cash flow statement. This gets you FCF:

Cash Flow from Operations - Capital Expenditure = FCF 

AT&T's free cash flow was negative $2.2 billion for the 2000 financial year - more cash was going out than coming in - it was nowhere near generating sufficient cash flow to cover its dividend payments. Hustling to find cash, AT&T was forced to slash its dividend payment. Investors, however, should have started getting worried before FCF reached this dire level. If you go back and do the same FCF calculation for the previous periods, you will spot a substantial downward trend.

Another important factor to consider in relation to cash flow is debt. If a cash-flow crunch forces a company to choose between paying dividends and paying interest, invariably shareholders lose out since failure to pay interest could force a company into bankruptcy. Furthermore, failure to meet debt obligations can damage a company's credit rating, so, depending on the conditions attached to its debt, a company can be forced to pay it off immediately in full.

Notice AT&T's debt levels soared in the run-up to its dividend cut. At the end of 2000, AT&T's long-term debt on the 10-K's Consolidated Balance Sheet was $33.1 billion; compared to $23.28 billion in 1999. Looking up a few lines, you will see that at the end of 2000, $31.9 billion of AT&T's debt was due to mature the following year.

High Yield When assessing dividend risk, be sure to look at the company's dividend yield, which measures the amount of income received in proportion to the share price. The dividend yield, expressed as a percentage, is calculated as the annual dividend income per share, divided by the share's current price:

 Dividend Yield  = Annual Dividend Income per Share / Share Price

When analyzing dividend yield, look at how the company's dividend compares to other companies in the industry. A higher-than-average yield is likely to be a harbinger of dividend cuts.

Consider AT&T's dividend yield on Nov 22, 2000 - just a month before its dividend cut. You can find AT&T's historical share prices under its 'Investor Relations' section by clicking on 'Stock Information'. Type in the date information and you'll find that AT&T closed at $18.67 on Nov 22, 2000. Dividing AT&T's dividend of $0.88 by $18.67 gives a dividend yield of 5%.

While 5% may not seem excessive, at the time, normal yields in the telecom industry were in the 2-4% range. On the day that AT&T announced the dividend cut (Dec 22, 2000), its share price fell to $16.68, translating into a yield of just 1% for investors.

Conclusion Investors should be on the constant lookout for potential problems with their dividend-paying stocks. Determining a stock's dividend payout ratio, backing it up with earnings and cash-flow trends, and scrutinizing dividend yield can help investors spot potential trouble. Although you might not necessarily need to sell your dividend-paying stock at the first sign of weakness, it is a good idea to thoroughly investigate for potential hazards.

by Ben McClure, (Contact Author | Biography)

Ben is director of McClure & Co., an independent research and consulting firm that specializes in investment analysis and intelligence. Before founding McClure & Co., Ben was a highly-rated European equities analyst at London-based Old Mutual Securities.