Dividend Payout Ratio: How an Auditor Checks Whether a Dividend Is Safe

The dividend payout ratio is the share of a company's profit that it pays out as dividends: dividends per share divided by earnings per share. A company that earns $3.00 per share and pays $1.80 has a payout ratio of 60%.

On its own, that number does not tell you a dividend is safe. Profit is an accounting figure, and dividends are paid in cash. I worked as a financial auditor at a Big Four firm, and the habit that job leaves is simple: read the earnings, then check them against the cash flow statement and the balance sheet.

This guide follows that order. It then shows what the three checks looked like at General Electric, Intel and Walgreens in the year before each one cut its dividend, using the figures from their own annual reports.

The three checks at a glance

Check 1: the dividend payout ratio

Payout ratio = dividends per share ÷ earnings per share

You can also use totals: total dividends divided by net income. The two results are close but not always identical, because share counts change during the year. Use one basis consistently.

Where to find each number in an annual report (Form 10-K for US companies):

• Earnings per share. At the bottom of the income statement. Use the diluted figure.
• Dividends declared per share. On the income statement just under earnings per share, or in the statement of shareholders' equity.

A worked example. A company reports this for the year:

The company keeps the other 40%, or $480 million, to reinvest or to absorb a bad year.

A ratio above 100% means the company paid out more than it earned. A negative ratio means it paid a dividend while making a loss. Neither can go on for long without help from somewhere else.

Check 2: the free cash flow payout ratio

Earnings can mislead in both directions. They include costs that use no cash, such as depreciation and write-downs. They also include sales that have been booked but not yet collected. And they ignore what the company spends on new plants and equipment, because that spending is spread over many years as depreciation.

The cash flow statement removes those effects. Free cash flow is the cash left after the business has paid to run and maintain itself:

Free cash flow = cash from operating activities − capital expenditure

That is the usual definition, the one the SEC staff describes in its guidance on non-GAAP measures. The same guidance warns that free cash flow has no uniform definition, so check how each company calculates the figure it publishes. The safest route is to compute it yourself from the cash flow statement:

• Cash from operating activities. The subtotal of the first section.
• Capital expenditure. In the investing section, usually called "additions to" or "purchases of" property, plant and equipment.
• Dividends paid. In the financing section.

Free cash flow payout ratio = dividends paid ÷ free cash flow

Same company as above:

On earnings, this dividend looks comfortable at 60%. On cash, the company paid out $120 million more than it generated. That $120 million came from borrowing, from cash in the bank or from selling something. One year like this is not alarming. Several in a row is the pattern seen in the cuts described below.

Check 3: the balance sheet

Lenders are paid before shareholders. Interest is a contract. A dividend is a decision the board takes every quarter and can reverse. When cash gets tight, the dividend is cut long before a debt payment is missed.

The SEC guidance makes the same point: free cash flow is not all available for dividends, because debt repayments are not deducted from it.

Two things to look at:

• Is total debt rising while free cash flow does not cover the dividend? Total debt is on the balance sheet (short-term plus long-term borrowings) and detailed in the debt note. If it climbs year after year while the dividend is not covered, the dividend is being paid with borrowed money.
• Interest cover. Operating income divided by interest expense, both on the income statement.

Our example company has operating income of $1,700 million and interest expense of $340 million:

Interest cover = $1,700m ÷ $340m = 5.0 times

Operating profit could fall a long way before interest becomes a problem. At 2 times, half of the operating profit already goes to lenders. There is no official threshold. What matters most is the direction over several years.

Three dividend cuts, checked against the annual reports

Each column shows the last full financial year before the cut. Amounts are in millions of dollars, except per-share figures.

Sources: GE 2016 Form 10-K, Intel 2022 Form 10-K, Walgreens Boots Alliance fiscal 2023 Form 10-K. GE figures are consolidated, including GE Capital, and operating cash flow is from continuing operations. Free cash flow is calculated here as operating cash flow minus additions to property, plant and equipment, not as each company's own adjusted measure.

General Electric. GE earned $0.89 per share in 2016 and declared $0.93, a payout ratio of 104%. On earnings from continuing operations ($1.00 per share) it was 93%. Cash from continuing operations was $6.1 billion, which covered only 69% of the $8.8 billion of dividends paid, before any capital expenditure. In November 2017 GE halved its quarterly dividend from $0.24 to $0.12, saying the aim was to align the payout with cash flow generation.

Intel. This is the case where the payout ratio alone would have reassured you. Intel paid out 75% of its 2022 earnings. But it spent $24.8 billion on property, plant and equipment against $15.4 billion of operating cash flow, so free cash flow was minus $9.4 billion, and it still paid $6.0 billion in dividends. Total debt rose from $38.1 billion to $42.1 billion over the year. In February 2023 Intel reduced its quarterly dividend from $0.365 to $0.125.

Walgreens. In fiscal 2022 Walgreens looked fine: a payout ratio of 38% ($1.9125 on earnings of $5.01 per share) and a free cash flow payout ratio of 77%. One year later it reported a loss, operating cash flow had fallen from $3.9 billion to $2.3 billion, and free cash flow was $141 million against $1,659 million of dividends. The same cash flow statement shows $1.8 billion of proceeds from sale-leaseback transactions. In January 2024 the company announced a 48% reduction of its quarterly dividend, to $0.25.

In all three cases the cash flow statement showed the problem at least as clearly as the payout ratio. At Intel, only the cash flow statement showed it.

Warning signs that tend to come before a cut

None of these proves a cut is coming. Together they describe most of the cuts above.

• Free cash flow below the dividend for more than one year.
• Debt rising while the dividend is not covered. Intel in 2022.
• A payout ratio that climbs because earnings fall, not because the dividend rises.
• Asset sales funding the payout. Walgreens in fiscal 2023.
• Dividend growth slowing to almost nothing.
• A dividend yield far above the company's peers.

The last two deserve a short explanation.

Dividend yield: why a very high one is often a warning

Dividend yield = annual dividend per share ÷ share price

A stock at $45 that pays $1.80 a year yields 4.0%. If the price falls to $22.50 and the dividend has not changed yet, the yield becomes 8.0%. Nothing improved. Investors are pricing in the risk that the $1.80 will not last.

An unusually high yield is a reason to run the three checks. Index providers apply the same caution: the S&P U.S. Dividend Growers Index requires at least 10 consecutive years of dividend increases and excludes the top 25% highest-yielding eligible companies.

Dividend growth: watch the pace

Dividend growth rate = (this year's dividend ÷ last year's dividend) − 1

A dividend that rises from $1.70 to $1.80 has grown 5.9%. Growth that the business can afford comes from rising earnings and cash flow. If the dividend grows faster than earnings for years, the payout ratio rises with it and the cushion shrinks.

A board that is running out of room often slows the increases before it cuts. GE's annual dividend rose 12.7% in 2014, 3.4% in 2015 and 1.1% in 2016, according to the five-year table in its 2017 Form 10-K. Walgreens raised its dividend by 1.7% in fiscal 2022 and 0.4% in fiscal 2023.

Valuation models such as the dividend discount model depend on that growth rate too, which is one more reason to check that the growth is covered by cash.

What is a good payout ratio?

There is no official threshold. The ranges below are common rules of thumb, not rules, and the right comparison is always the company's own history and its direct competitors.

Why REITs are different. A REIT must distribute at least 90% of its taxable income to shareholders each year, as the SEC's investor bulletin on REITs explains. Its earnings per share are also reduced by depreciation on buildings, a cost that uses no cash. The result is that a healthy REIT can show a payout ratio well above 100% of earnings.

The industry therefore uses funds from operations (FFO). Nareit defines FFO as net income excluding depreciation and amortization related to real estate, gains and losses from the sale of certain real estate assets, and certain impairment write-downs. The SEC staff accepts that definition. Adjusted FFO (AFFO) goes one step further and usually subtracts the recurring spending needed to maintain the properties. AFFO has no standard definition, so each REIT's version has to be read in its own report.

For a REIT, divide the dividend per share by FFO or AFFO per share. REIT dividends are also taxed differently, which is covered in how dividends are taxed.

Sector mix matters too. If most of your income comes from one sector, one bad cycle can hit several of your dividends at once.

What to do when the signs appear

A warning sign is a reason to look closer, not a verdict. Three practical steps:

1. Read what the company says. The liquidity section of the annual report explains how the payout is funded.
2. Separate one-off from recurring. A single write-down can push the payout ratio above 100% for a year without touching cash. A free cash flow shortfall that repeats is a different matter.
3. Know your exposure. Work out what share of your yearly dividend income comes from that one company. It matters most if you plan to live off dividends.

What you then do with the position depends on your own situation.

OnlyDividends does not calculate payout ratios; those come from the company's reports. Its calendar labels every payment as Received, Confirmed or Estimated, so you can tell a dividend the company has declared from one that is only projected. Other ways to follow your income are compared in how to track your dividend income.

Frequently asked questions

What is a good dividend payout ratio?

There is no official number. As a rule of thumb, many mature companies sit between about 40% and 70% of earnings, growing companies lower, and regulated utilities higher. Compare the ratio with the company's own past and with its competitors, and check it against free cash flow.

What is the free cash flow payout ratio?

It is dividends paid divided by free cash flow, where free cash flow is cash from operating activities minus capital expenditure. All three numbers are on the cash flow statement. It shows whether the business generated the cash it paid out.

Is a payout ratio over 100% bad?

It means the company paid out more than it earned that year. That can be harmless if a one-off, non-cash charge pulled earnings down and free cash flow still covers the dividend. It is a serious warning if it lasts, or if free cash flow is also below the dividend.

How do I know if my dividend is safe?

No check gives certainty. Run three: the payout ratio on earnings, the free cash flow payout ratio, and debt with interest cover. Then look at the trend over several years.

What are the warning signs of a dividend cut?

Free cash flow below the dividend for more than a year, debt rising to fill the gap, a payout ratio climbing because earnings are falling, dividend increases shrinking to almost nothing, and a yield far above comparable companies.

Is a high dividend yield a good sign?

Not by itself. Yield rises when the share price falls, so a very high yield often means investors expect a cut. Check the payout ratio and free cash flow before reading anything into the yield.

Why do REITs have payout ratios above 100%?

Because their earnings are reduced by depreciation on real estate, which uses no cash, and because they must distribute at least 90% of their taxable income. REIT dividends are compared with FFO or AFFO instead of earnings per share.

Disclaimer

This article is general information, not investment advice, and it does not recommend buying or selling any security. The company figures are historical, taken from the filings linked above, and say nothing about those companies today. Past dividend cuts do not predict future ones. Check the latest reports and consider your own situation before you act.