FTSE 250 dividend cut? A couple of warning signs I’d watch!

This FTSE 250 share cut its dividend this year. Our writer explains why he wasn’t surprised, based on how he assesses income shares.

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Few investors like it when a company cuts its dividend. But it is always a risk for any income share. But whereas FTSE 100 dividend cuts may generate headlines, some FTSE 250 shares slash their payouts without attracting the same sort of attention.

Yet a cut is a cut – and can be painful when it comes to the passive income streams one earns from a portfolio.

That explains why I diversify my portfolio across a range of different shares. But as an investor, it is also important to understand some of the possible signs that a dividend cut might be coming.

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Unusually high yield

Have a look at this chart. Do we notice anything unusual?

Created using TradingView

It shows a dividend yield that stood at around 12% three years ago. But that then increased to almost 20%. In other words, for every pound I invested in this share, I would have got back 20p per year – if the dividend was maintained at that level.

Some shares have high yields and maintain or increase their payouts. But an unusually high yield – and 20% is definitely that for a FTSE 250 share – is a red flag for me. I would want to know why the yield was so high and judge what the future looked like for the dividend.

Sometimes a yield is high because a business had a particularly good year.

In other cases, it reflects the share price moving down as investor nervousness grows about the sustainability of a dividend.

That is exactly the case here. The yield chart above relates to Diversified Energy (LSE: DEC). The FTSE 250 share has fallen 62% in five years.

Created with Highcharts 11.4.3Diversified Energy Plc PriceZoom1M3M6MYTD1Y5Y10YALLwww.fool.co.uk

Growing debt

Diversified Energy announced a dividend cut in March, which did not surprise me at all. Partly that lack of surprise was because of the company’s balance sheet – something else I pay close attention to as an investor.

At $1.3bn, it had slightly less net debt at the end of last year than 12 months before.

Created using TradingView

Still, for a company that has a market capitalisation of around £440m (roughly $527m) at the moment, that is an uncomfortably high debt in my opinion.

Debt matters when it comes to dividends because the higher a company’s debt, the less financial flexibility a company typically has. Even if it generates large cash flows, it may need to use them to service debt, not to pay big dividends.

That is true of a FTSE 100 firm too — but a FTSE 250 company can find accessing finance more costly than a far larger company in the main index.

Looking for great companies not just high dividends

There are a host of other indicators I look at when considering what might happen to a share’s dividends in future. These are only two of them.

In short, instead of focusing on yield, I ask myself what a company’s long-term commercial prospects look like and what that might mean for shareholder payouts.

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Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

C Ruane has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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