Dividends are a source of regular income for investors. Because of that, it should be no surprise that the dividend yield of a share is an important part of the investor’s decision-making process as it clues an investor in to the current income he or she can receive.
But, it can be dangerous to focus on a share’s dividend yield alone.
Instead, here are two metrics that investors can include in their tool-kit for a better analysis of a company’s dividends: Free Cash Flow; and Net Cash Balance.
What’s a Free Cash Flow?
In the daily course of every business, it either generates or consumes cash. When a business is able to generate cash, it then uses the cash to touch-up existing income-producing assets. After which, any left-overs can then be allocated by management to pay out dividends; make acquisitions; expand the business’s asset base; store it in the proverbial “vault”; or buy-back shares, among others.
That left-over cash is known as Free Cash Flow. Mathematically, the numbers can be gleaned from a company’s Cash Flow Statement and the equation’s given as:
Free Cash Flow = Cash Flow from Operations – Purchase of Property, Plant & Equipment (otherwise known as Capital Expenditures)
… And What’s a Net Cash Balance?
The Net Cash Balance tells us how much cash a company has stored up for future use, net of all debt. Companies with a large Net Cash Balance have an additional safety net to rely on to pay creditors, bills, suppliers, wages, loans, even dividends etc. when its business runs into any temporary slowdown in which it is unable to generate sufficient cash.
The required figures are found in the company’s Balance Sheet and its equation is given as:
Net Cash Balance = Total Cash & Equivalents – Short-Term Debts & Long Term Debts
Why the cash is important
While dividend investors often like to focus on the pay-out ratio, which measures dividends as a percentage of net income, we have to bear in mind that ultimately, dividends are paid out in cash.
Companies can report great profits but without booking the actual cash into its coffers, it is going to find it difficult to pay out dividends in the future. So, even though it’s important for companies to have profits, we should also keep an eye on the cash.
A Tale of Two Dividends
Let’s use Japanese ramen-restaurant operator Japan Foods Holding (SGX: 5OI) and industrial fishing company China Fishery Group (SGX: B0Z) as examples on the importance of the two metrics: Free Cash Flow and Net Cash Balance.
| Company | Price per share | Dividend Yield* |
| Japan Foods | S$0.79 | 3.2% |
| China Fishery | S$0.375 | 5.1% |
| *Based on last completed financial year’s full-year payout | ||
Both companies have dividend yields higher than the Straits Times Index’s (SGX: ^STI) yield of around 2.6% (using the index tracker SPDR STI ETF’s (SGX: E3B) data as a proxy) so they might both be considered attractive dividend shares on that basis alone.
China Fishery might even be considered the more lucrative of the two based on its higher yield. But, a different picture emerges when we consider the companies’ Free Cash Flow and Net Cash Balance, as seen from the charts below.
We can see from the charts that Japan Foods has seen both its Free Cash Flow and Net Cash Balance grow steadily over its last five completed financial years (FYs). Meanwhile, China Fishery has had cumulative Free Cash Flow of negative US$15m over its last five completed FYs and consistently carried more debt than cash.
Under such a backdrop, it’s not that surprising to see China Fishery’s dividend fall to 1.9 Singapore cents per share for FY 2012 from a bonus-share-adjusted 5.48 Singapore cents per share for FY 2008.
Investors who tracked profits alone would likely be left scratching their heads on the big drop in dividends as the industrial fishing company’s earnings per share dropped by ‘only’ 30% from US$0.11 to US$0.076 in the same time period.
But for those who had been keeping an eye on China Fishery’s Free Cash Flow and Net Cash Balance, it would have been clearer to them that the company was just not able to bring in sufficient cash.
Meanwhile, Japan Foods – with growing Free Cash Flows and a balance sheet that becomes healthier with each passing year – has been able to grow its dividends from a bonus-share-adjusted 0.167 Singapore cents in FY 2009 to 2.5 Singapore cents in FY 2013 as the company is able to generate ample cash from its daily job of dishing out ramen and more to diners.
The Japanese ramen-restaurant operator, with its historical ability to generate Free Cash Flow and to maintain a healthy balance sheet, could be seen as a better choice than China Fishery for future dividends, ceteris paribus.
That’s especially so in light of the higher perceived risk of the latter dropping its dividends still further if it continues to struggle in producing meaningful Free Cash Flows from its business in the future.
Foolish Bottom Line
Every publicly listed company has to prepare three financial statements: the Income Statement; Cash Flow Statement; and Balance Sheet. All three have to be studied together to paint a holistic picture of a company’s financials and business condition.
That’s important for every investor – not just for dividend investors – to keep in mind.
