Are you looking for companies that can hold and grow their dividend? In making this determination, a company’s income statement is one of the last places you should look Cash is king for them Dividend growth investor and the Cash flow statement This is where smart investors come in when they want to understand a company’s viability.

It’s not that most companies got it wrong when they created their income statements, but under GAAP, many of the entries have nothing to do with doing business today. Because of this, I generally avoid most earnings-related metrics (e.g. EBIT, EBITDA, payout ratio, etc.). Instead, I focus on cash-based metrics like these:

Free cash flow – This has a lot of definitions, but the one I am using is operating cash flow minus capital expenditures. Investments are deducted because you cannot run a business for a period of time without raising a certain amount of capital. These two numbers are easy to find in the cash flow statement. This is the best snapshot of what cash the company has generated from “normal” operations and is available for dividends, debts, acquisitions and purchases of its own shares.

Cash flow per diluted share – GAAP earnings per share (EPS) have the same shortcomings as GAAP earnings. When looking at EPS numbers, I prefer a cash based number. The cash flow per diluted share is calculated by taking the free cash flow from above and dividing it by the diluted shares outstanding (available on the income statement).

Cash payout rate – Dividend investors love payout ratios (dividends per share / EPS). Again, given my GAAP earnings and EPS concerns, I prefer a cash-based version. The cash payout ratio is calculated by dividing the dividend per share by the cash flow per diluted share. Care should be taken in interpreting this relationship. For example, sometimes a high ratio with low debt is better than a low ratio with high debt.

Debt to total capital – Total capital is the sum of borrowed capital plus equity (both available on the balance sheet – don’t forget the debt classified as short term). Businesses are typically financed in two ways: equity or debt. Usually debt is more expensive than equity, while additional equity can potentially dilute current shareholders in the long run. I consider 35% debt and 65% equity to be a good balance. I see the top end of debt at 50% and then there has to be a good reason for it.

Cash return on capital employed – This is simply the free cash flow divided by the total capital (both are defined above). Again, I prefer using a cash number in the meter. Many investors watch out for return on investment and return on equity. Everyone is flawed beyond their GAAP counter. The return on capital ignores the liabilities side of the balance sheet, while the return on equity ignores the leverage component of capital.

To be successful as a dividend investor, you need to find companies that can hold and grow dividends by focusing on their ability to generate cash. You can fake revenue, but you can cannot counterfeit cash.

Full Disclosure: No position in the above securities.

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