Retirement Income Equity Selection Factor 5: Dividend Coverage

By: Bruce Miller, CFP®

Some prospective retirement income investors may want to stop and use the four selection factors — Dividend Yield, Dividend History, Dividend Growth Rate and the Nature of the Business — described in my previous articles as prima-facie evidence that a company will or will not likely sustain and grow its future dividends. These tests can be done relatively quickly and do not require any deeper understanding of company workings. Some investors have no desire to examine and interpret company financial filings and annual shareholder reports or do some necessary math operations to get a better picture of how well the company is covering its dividend. In most cases, the first four retirement income selection factors will be sufficient for making a reasonably suitable selection of retirement income securities.

However, there are cases of long-time dividend growth stocks that cut their dividends suddenly and with little warning. Examples here include Pfizer (NYSE:PFE) and Avon (NYSE:AVP). Their dividend histories and growth rates looked fine until the companies cut their dividends abruptly. While there are few stocks like these two examples, investors need to analyze additional information for a more complete dividends evaluation.

Therefore, I would encourage even those who think they have no interest in the company’s financials, to continue reading and at least get a sense of some financial reporting basics. The concepts and math involved are not difficult. It takes only a little time to understand the fundamentals and work through a couple of examples to understand the information. The process is not that different from managing retirement household cash flow.

Retirement Income Dictum #4: Source of Dividends

Company dividends and distributions from Master Limited Partnerships (MLPs) are paid from Operating Cash flow and not from earnings

Before continuing to discuss a company’s ability to cover its dividend, I will digress a bit and discuss standard company financial reporting.

The Securities and Exchange Commission (SEC) requires all but the smallest publicly traded companies to disclose quarterly to their shareholders and the public at large three important financial summary statements. These statements report company’s financial results for the most recent quarter — the 10Q report — and for the company’s complete fiscal year, which is an annual comprehensive shareholder report — the 10K report. The company also must report any significant event during the year on a separate report — referred to as an 8K report.

While there are other reporting requirements, we will focus just on these three main ones for now. The three standard financial reports that companies must provide are the Statement of Earnings, also called the Income Statement; the Statement of Financial Position, also known as the Balance Sheet; and the Statement of Cash Flows. All these reports have a standard reporting format that all companies must follow and that are set under the Generally Accepted Accounting Principles (GAAP) developed by the Financial Accounting Standards Board.

These required filings are separate from the tax filing each business entity must file each year to the Internal Revenue Service (IRS), although the Statement of Earnings very closely follows the company’s tax return. While all companies must follow the standard format for reporting, that does not mean that all companies will interpret all reporting identically. The company’s financial reports must follow these standards and the reports must be subject to independent audits to ensure compliance. A failure to follow standard reporting can result in fines from the SEC, detailed audits by the IRS and shareholder lawsuits. Companies have high incentives to follow these standards.

Statement of Earnings (Income Statement)

This report begins with revenues or sales, whether cash has been received or not — and gradually subtracts company expenses — whether these expenses have actually been paid in cash or not. As mentioned previously, the Statement of Earnings closely follows the company’s tax return and includes some revenues and expenses that do not involve the movement of cash. Examples include non-cash expenses such as depreciation of investment property, amortization of the cost of purchasing an intangible asset such as a patent or using an average of rents collected over a lease period rather than the actual increasing rents collected. Similarly, some expenses reported on the Statement of Earnings may involve only part of the actual expenses paid. For example, if a company pays $48,000 for property taxes, but this payment only covers three months remaining in the fiscal year, the Statement of Earnings will show only those three months as an expense of $12,000, despite the company having actually paid out $48,000.

Therefore, I tend to look at the Statement of Earnings as essentially an IRS report whose format and content is to ensure that companies pay every dollar of tax that they owe. The IRS is not concerned about the coverage of the company’s dividend and they do not care about dividend sustainability. In turn, I do not care how the company goes about determining their tax bill for the year.

The earnings reported on this statement and the broadly reported earnings per share (EPS) by the media, will usually correlate with cash flow available to pay dividends. But then, as in the case of Master Limited Partnerships, it may have little correlation to the cash flow. Often, one will see a company report its Earnings Before Interest Depreciation and Amortization (EBITDA). This is a non-GAAP metric that can show the actual core cash flow generated by company operations. However, because EBITDA does not have to conform to GAAP reporting rules and is therefore unaudited, unscrupulous company executives can manipulate the EBITDA — or an adjusted version of it — to make their financial condition look better than it is.

The three line items on the statement of earnings of most interest to pure retirement income investors should be the company’s gross revenues — sometimes referred to as sales — interest expense and the amount they pay out in preferred dividends.

Statement of Financial Position (Balance Sheet)

The Statement of Financial Position shows all the assets of a company, the claims on those assets by creditors – liabilities — such that subtracting the liabilities from the assets shows the owner’s equity. Generally, the larger the owner’s equity, the easier it will be for the company to borrow money to pay for new investments. These new investments should add to the company’s revenues and eventually, to larger operating cash flow and better dividend coverage.

A company that is selling its assets and using proceeds to pay its dividend when Net Operating Cash Flow is insufficient will have difficulties sustaining its dividend distributions. However, monitoring the trend in the size of the owner’s equity is important. The balance sheet is also used to measure the amount of debt carried by a company, with metrics such as debt divided by equity (debt-to-equity) or debt divided by total assets (debt-to-assets) ratios. I do not find this very useful as a measure of a company’s ability to sustain and grow their dividend. The total dollar value of the debt is irrelevant. The only relevant information is how much the company is paying in fixed interest costs as a ratio of the company’s Net Operating Cash Flow that really matters. Every added dollar of interest is a dollar that is not available to be paid as a dividend. Thus, the only item on the balance sheet that interests me is the owner’s equity.

Statement of Cash Flows (SCF):

The Statement of Cash Flows is the most recent of the required financial statements required to be reported — required since 1988. This GAAP reporting document is the most important and retirement income investors will find the most valuable information in this report. This report shows the company’s cash — after paying all operation expenses — available to pay for dividends and some capital expenses.

The Statement of Cash Flows reports the actual cash that the company has. It does not report theoretical earnings, some surrogate measure of cash flow such as EBITDA or other ratios. Investors looking for company growth that the markets will reward with a high per share price will not find much useful information in this report. This document is simply an accurate and boring accounting of where the company’s cash actually went and whether the company can pay and grow its dividend. The Statement of Cash Flows is the core document of the retirement income investor. Because of its importance, I will dedicate a few additional articles to explaining the Statement of Cash Flows in more detail.

Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.