“Allowances could be made for certain industries where earnings are fairly predictable, but anything volatile or cyclical needs taking a look at if the ratio is below two,” he said. “It might be best to take a look at average cover over say 10 years, or a full economic cycle, to ensure that this yr isn’t one wherein cover looks good because earnings are at a cyclical high.”
The health of an organization’s balance sheet can also be critical to its ability to keep up dividend payments. “A heavily indebted company can have to pay interest on its liabilities and repay them at some stage,” Mould said. “Ultimately a firm could have to scale back and even suspend its dividend to preserve money and ensure its banks are paid so that they don’t pull the plug.”
He said one good measure of the strength of an organization’s balance sheet was its “gearing”, or the ratio of its net debts to net assets. It’s calculated by first adding short-term borrowings to long-term borrowings and pension liabilities and taking away money and “money equivalents”. This figure is then divided by shareholders’ equity (or “net assets” or “book value”) after which multiplied by 100 to succeed in a percentage.
“A positive figure shows the corporate has net debt, a negative one net money,” Mould said. “Crudely put, the lower the ratio the stronger the balance sheet. Nonetheless, firms with relatively predictable money flows, equivalent to utilities, will have the option to hold higher debts more comfortably than cyclical ones, whose income swings around in a much less predictable manner.”