Description: This ratio is used by investors to see if a company is generating a sufficient level of cash flow to assure a continued stream of dividends to them. A ratio of less than one indicates that existing dividends are at a level that cannot be sustained over the long term.
Formula: Divide total annual dividend payments by annual cash flow. If there is a long-standing tradition by the board of directors of continually increasing the amount of the dividend, then annualize the last (and presumably largest) dividend only and use the resulting figure in the numerator of the calculation. The formula is:
Example: The Williams Fund is a major investor in the Continental Gas and Electric Company. The Fund is controlled by the Williams family, whose primary concern is long-term, predictable flow of cash from its various investments. The family is concerned that electricity deregulation may be impacting the ability of Continental Gas to pay dividends. It has collected information about Continental for the past three years, shown in Table 4.9.
The table reveals that Continental's board of directors is continuing to grant increasing amounts of dividends, despite a steady drop in cash flow. At the current pace of cash flow decline, Continental will be unable to support its current dividend rate in less than two years.
Cautions: Cash flows can vary significantly by year, so calculating this ratio for one year only may not yield sufficient information about a company's ability to pay dividends over the long term. A better approach, as was used in the example, is to run a trend line on the ratio for several years to see if a general pattern of decline emerges.
Total dividend payments
Net income + Noncash expenses - Noncash sales
Total dividend Cash flow
Dividend payout ratio
Was this article helpful?