Wednesday, October 14, 2009

Debt coverage for sustainable dividends

Most companies use debt for a variety of reasons in their operations. It could be either short term or long-term obligations. If there’s anything the 2007-2009 financial crisis has taught us, it is that excessively leveraged companies could easily blow up after a chain of negative events. Thus it pays to know what the debt situation for a particular company you are investing in actually is.

Some investors typically focus on debt to total assets to gain a perspective on the amount of the leverage the company has. While this method is widely accepted by some investors, I believe that it has some shortcomings, which might prevent investors from seeing the bigger picture. Most importantly comparing debt to total assets does not tell whether a company could service its debt obligations or not.

When you decide to get a loan from your bank, one of the most important questions they have is what your income has been, rather than provide a list of your assets and debts. Only when you provide a proof that you could service a new line of credit, would your banker provide you with a loan.

One method that I prefer is comparing annual earnings before interest and taxes to the amount of annual interest expense paid. While this ratio would vary for different types of enterprises, it should never the less provide an important glimpse to a company’s ability to service its debts when its trended over several years.

I highlighted the coverage ratios for the 51 components of the Dividend Aristocrats Index. Some of the members of this dividend basket have already cut distributions so I expect them to be booted out by the end of 2009. Here’s the list, which includes company name, ticker, industry, as well as the past 3 years worth of coverage ratios for each company:

You can open the table from this location.

Dividend investors should generally look for a higher coverage ratio of interest payments. A lower coverage indicates that a decline in earnings could generally make it difficult for the company to service its debt, which could not only jeopardize its dividend payments but also could lead to bankruptcy down the road.

Full Disclosure: I have a long position in most of the stocks mentioned in this list

Relevant Articles:

- Six things I learned from the financial crisis
- Dividend Aristocrats List for 2009
- Dividend Cuts - the worst nightmare for dividend investors.
- Dividend Investing Resources

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