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UK dividend investors can sleep easier

Good news for income seekers: the UK’s top 350 firms have seemingly bounced back with respect to their capacity to meet dividend payouts from their profits.

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However, I’d question whether the situation was previously really as bad as pundits had warned – and hence whether this apparent recovery is much more than an accounting quirk, at least from the perspective of a dividend investor.

Profit potential

Dividend cover represents the ratio of a company’s profits to the dividend it pays out to shareholders.

For instance, if a company makes £10m profit and pays out £5m, then the dividend cover is 2 times. That’s good, on the face of it, because it apparently shows a company barely breaking a sweat to meet its dividend commitments.

Imagine this company only makes £6m in profits. Let’s say it still pays £5m in dividends – perhaps the managing director can’t face all the angry shareholders if they cut the payout – so the buffer shrinks. Dividend cover is now 1.2 times.

Suppose next year things get still worse.  Profit falls to just £4m. Yet the company continues to pay out £5m in total dividends – topping up with cash it had previously set aside. This sad state of affairs is captured in a dividend cover figure of 0.8 times.

In other words, the dividend payout is no longer covered by profits!

Note that you can also calculate dividend cover on a per share basis by looking at earnings per share and comparing it with dividend per share.

It’s a cover up

So far, so straightforward, right? A high dividend cover is a good thing, and an uncovered dividend is not, conjuring up visions of managers hunting down the back of the sofa – selling assets, or even taking on debt – to keep shareholders happy with dividends, rather than cutting a payout that may eventually prove unsustainable.

That’s certainly the implication from these latest figures.

The Share Centre reports dividend cover doubled to 1.8 times for the FTSE 350, versus 0.8 times a year ago. And in case you’re wondering if dividends have been cut to boost cover, nope. Rather, UK Plc has seen profits “rocket”, we’re told.

Indeed the profit recovery of the FTSE 350 is described as “staggering”, with profits reported by the UK’s top 350 listed firms rising 157%, from £67.2bn to £172.7bn over the last year.

Meanwhile dividends paid rose 10% to £93.6bn.

What happened to the crash?

This is all a happy state of affairs, compared to what some once predicted.

During the past few years many warned the UK market could not afford its dividend largesse.

To quote one article from the Financial Times in January 2016 titled “Income Investor: FTSE 100 dividends in the danger zone”

Some of the apparent dividend yields on offer in the FTSE 100 look extremely tempting. That’s the good news. Before you gorge yourself, however, a health warning. The tell-tale sign of a possible dividend cut is when the yield on a share looks too good to be true. […]

When headline yields are this high, amber lights should start flashing, not least because dividend cover — the relationship of dividends to the profits from which they are paid — has fallen to its lowest level in six years.

Google throws up many articles like this from a few years ago. Given that the FTSE 100 is on-track to pay record dividends in 2018, these warnings look a bit odd now.

Cash is king

So what’s my beef? Am I incapable of enjoying good news, like some Victor Meldrew of the investing scene?

Well unlike Mr. Meldrew, I do believe it. I’m not quibbling with the profit figures.

But I do question how relevant reported profits are to dividend sustainability.

Accounting profits are not the same as cash flows. And dividends are paid out of cold hard cash.

In my opinion, the dividend cover crunch that got everybody so concerned in the past few years was caused by an unusual – and always likely temporary – suppression of profitability, exacerbated in particular by turmoil in the energy and mining sectors.

Affected companies took big write-downs as commodity prices tumbled. Giants from Royal Dutch Shell (LSE: RDSB) to Rio Tinto (LSE: RIO) reported huge accounting losses as a result.

There’s no denying they were tough times. But I believe the underlying cash flow picture – and the medium-term viability of these companies – was far less bleak than their enormous losses implied. And the share prices of these companies did indeed bounce back.

Many big UK businesses look in better shape than a few years ago. The weakening of the pound following the Brexit vote in 2016 also helped earnings, since most of their profits are earned overseas, and these are worth more when repatriated into weaker pounds.

And sure, the recovery in general dividend cover in the market is welcome.

But I think Foolish investors who buy shares in individual companies should always dig deeper into the financial statements of the companies they are considering investing in to evaluate the cash flowing through a business.

Looking at money entering and leaving a company’s bank account can give you a far better guide than reported profits as to how sustainable dividends will prove.

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Owain Bennallack 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.