Dividend Sustainability Assessment- A Look at Cash Flow

In this hub, I try to describe why I consider that cash flow is the main criterion that should be used when assessing the safety of a company's dividend. Note that this method is rendered useless in case a company does not pay any dividend (Apple and RIM are examples), or pays a very low dividend. 

The reason that I don't like much to rely on accounting figures in order to assess a company's financial health is because many accounting entries can be altered in order to come up with results showing the company in a too favorable way. Here are some examples:

- depreciation entries use historical values, that can possibly be completely different from current day replacement costs

- non-cash transactions (for example the sale of a subsidiary for stock) do not generate any cash, and should not be considered

Cash flow is usually split into 3 components:

- Cash flow from operations ("CFO"): this figure represents the amount of cash that got generated from the company's day-to-day's operations. There are 2 ways to calculate it (direct and indirect). I usually compare this figure with the dividend paid to see if the day-to-day operations are able to sustain the company's dividend

- Cash flow from investing ("CFI"): this figure is usually seen as the amount necessary in order to maintain the company's operations. It represents the change in financial position from the investments in subsidiaries, financial market instruments and capital assets

- Cash flow from financing ("CFF"): this figure represents the net cash change from the amount of stock outstanding (considering both issuance and re-acquisition) and the cash paid as dividends.

A quick way to assess if a company can afford to pay its current dividends in the long run is to compare this dividend with the figure (CFO - CFI). Note that this method is not perfect, and multiple adjustments have to be performed in order come up with more useful figure, but I will ignore those for the sake of keeping things manageable (usually these adjustments do not represent a major percentage change in the initial figures). In the next hubs, I will explain in more details how CFO, CFI and CFF are calculated, with some examples.