You will be able to calculate a payout ratio and judge whether a dividend is covered.
Imagine two colleagues who each give S$500 a month to their parents. One earns S$4,000 a month. The other earns S$1,200 and makes up the rest with a credit line. The gift is the same. Only one of them can keep it up next year.
A dividend works the same way. The size of the payout tells you very little until you set it against what the company earns, and that comparison has a name.
The payout ratio is dividends divided by earnings. You can work it out per share, dividends per share over earnings per share, or in totals, total dividends over net profit. Both give the same answer.
With made-up figures, say a company made a net profit of S$200 million last year and paid S$130 million in dividends. Its payout ratio is 65%. It handed out about two thirds of what it earned and kept a third to reinvest, repay debt or hold as a buffer.
When the ratio is above 100%, the company is paying out more than it earns. The extra has to come from somewhere: cash saved in earlier years, borrowing, or selling something. As lesson 1.2, Where dividends come from and how often they are paid, explained, that can go on for a while but not indefinitely.
Earnings come from accounting rules, and those rules involve judgement: when revenue counts, how fast equipment is depreciated, what an asset is worth. A company can report steady earnings while very little cash actually comes in.
That is why it helps to run the same test against cash. Free cash flow is the cash a business generates from operations, less what it spends on capital items such as equipment, buildings and systems. It is the money left over that could pay a dividend without borrowing.
Both figures are in the cash flow statement in the annual report. With made-up figures, say the same company had operating cash flow of S$260 million and spent S$150 million on capital items. Free cash flow is S$110 million. It paid S$130 million in dividends, so its free cash flow payout is about 118%.
That is a very different picture from the 65% on earnings. On paper the dividend is covered with room to spare. In cash, the company paid out more than it brought in and filled the gap from somewhere else. One year of this can have an innocent cause, such as a big one-off investment. Several years in a row is a warning, and lesson 3.2, Warning signs that a dividend is about to be cut, lists it.
The point of the ratio is to measure how much room is left. A company paying out 50% of earnings could see profits halve and still keep its dividend without dipping into savings. A company paying out 95% has almost no room: a small fall in profits forces a choice between cutting the dividend and funding it from elsewhere.
No single ratio is right for every business. A mature company with steady sales and little need to reinvest can carry a higher ratio safely. A company whose profits swing with the economy or commodity prices needs more room. So read the ratio alongside the business. A high payout ratio in a steady business is a smaller concern than the same ratio in a cyclical one.
Two kinds of payer, both large on SGX, do not fit the usual test.
Banks hold capital to absorb losses, and MAS sets the capital rules they must meet. A bank's dividend depends on its earnings and also on how much capital it has above what the rules require. Free cash flow means little for a bank, because lending and taking deposits is its business. For a bank, read the payout ratio on earnings and the capital ratios reported in its results, and look up the current requirements on the MAS website if you want to see the margin.
REITs pay out most of their income by design. Lesson 4.2, The payout rule and tax transparency, explains why. A REIT with a payout ratio of 90% or more is doing what it was built to do, and a payout ratio test that would alarm you in a manufacturer tells you nothing about a REIT. The REIT tests are different, and module 5 covers them.
For any company that is not a bank or REIT, you need four numbers from the latest annual report: net profit attributable to shareholders, total dividends declared for the year, operating cash flow, and capital expenditure. The first two are in the income statement and the dividend note. The last two are in the cash flow statement.
Use the dividends declared for the financial year, both interim and final, and leave out any special. Then do the two divisions.
In the activity you will pull those four numbers for one SGX company and calculate both ratios, and the gap between them, if there is one, is what you will want to explain.
Using the latest annual report of one non-REIT SGX company, calculate its payout ratio on earnings and on free cash flow.
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