Last week I warned you to not simply buy a stock because it has a sky-high dividend yield.

You see, investors often forget that dividends are by no means guaranteed. A company can cut or completely eliminate it at any time.

That’s why it’s important to do your due diligence. Does the company have a strong track record of making payments? Is it paying out more in dividends than it makes in earnings (that’s not sustainable!)?

But I like to dig a little deeper than just earnings and look at cash flow as well…

Earnings and sales can easily be “massaged” to fit management’s narrative. But cash flow is much harder to fudge. Strong cash flow is necessary for a company to continue dishing out dividends to shareholders.

Cash flow strips out non-cash charges (think depreciation and amortization) as well as one-time gains and losses. It reflects the true amount of cash flowing in and out of the business.

Once you subtract out capital expenditures from operating cash flow you get free cash flow (FCF). This is the pool of cash that is used to pay dividends and repurchase shares.

If a company has weak (or negative) free cash flows, then you must ask yourself where the money is coming from to continue supporting the dividend.

Finally, look at how well the company is managing its debt levels.

This one can be a little tricky, because not all debt is created equal. But the bottom line is that a heavy debt burden can be a major drag on a firm’s financials and outlook. Unfortunately, there’s no metric that tells you how much debt is too much. It varies between industries and companies.

But one simple evaluation tool you can look at is a firm’s debt-to-EBITDA. A ratio of 4.0 means it would take four years for a company to repay loans using current annualized cash flows. Debt-to-equity is also useful. But what’s reasonable for one company might be high for another.

You can’t compare an automaker, for example, with a bank.

Another ratio to keep an eye on is a firm’s current ratio (current assets/current liabilities). This liquidity gauge tells you how much in assets the company has compared to liabilities.

If a company has $10 million in cash, accounts receivable and other assets against $5 million in notes payable and other current liabilities, then it has a ratio of 2 — meaning $2 on hand to pay every $1 owed over the next 12 months.

That’s solid. Obviously, a company with more assets than liabilities is in a much stronger financial position than a firm where its liabilities outweigh its assets.

The bottom line is that not all dividend-paying stocks are created equal.

Sure, you can go nab a company with a massive yield, but you might find that because of its poor finances, its share price falls, and assuming it keeps its dividend payout the same, its yield will rise. But does the dividend yield offset the capital loss? Unlikely.

Monitoring payout ratios, cash flow generation, and debt levels can help put you on the right path to finding a company whose dividend will be around for decades to come.

If you want even more information about investing in dividend stocks, check out my Income Manifesto — a book I wrote that covers everything you need to know about dividend investing.

It covers why everyone should consider investing in dividend stocks… Why dividend stocks outperform the market with less risk…. Common misconceptions about income stocks… Plus my 3 favorite dividend-paying stocks right now.

Get my Income Manifest here!

Roger Scott

Monday Morning Paydays

P.S. If you ever have any feedback or questions, don’t hesitate to email. We read and appreciate every single message I receive. What you email me about today could very well be the subject of my next issue. So don’t hesitate to contact me at Roger@MondayMorningPaydays.com.