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Is Inchcape plc (LON:INCH) At Risk Of Cutting Its Dividend?

Simply Wall St

Dividend paying stocks like Inchcape plc (LON:INCH) tend to be popular with investors, and for good reason - some research suggests a significant amount of all stock market returns come from reinvested dividends. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.

With a goodly-sized dividend yield despite a relatively short payment history, investors might be wondering if Inchcape is a new dividend aristocrat in the making. It sure looks interesting on these metrics - but there's always more to the story . The company also bought back stock during the year, equivalent to approximately 1.1% of the company's market capitalisation at the time. Some simple research can reduce the risk of buying Inchcape for its dividend - read on to learn more.

Explore this interactive chart for our latest analysis on Inchcape!

LSE:INCH Historical Dividend Yield, January 28th 2020

Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, then the dividend might become unsustainable - hardly an ideal situation. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. Looking at the data, we can see that 207% of Inchcape's profits were paid out as dividends in the last 12 months. Unless there are extenuating circumstances, from the perspective of an investor who hopes to own the company for many years, a payout ratio of above 100% is definitely a concern.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. The company paid out 52% of its free cash flow, which is not bad per se, but does start to limit the amount of cash Inchcape has available to meet other needs. It's disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and Inchcape fortunately did generate enough cash to fund its dividend. If executives were to continue paying more in dividends than the company reported in profits, we'd view this as a warning sign. Extraordinarily few companies are capable of persistently paying a dividend that is greater than their profits.

Is Inchcape's Balance Sheet Risky?

As Inchcape's dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. A quick check of its financial situation can be done with two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. Inchcape is carrying net debt of 3.85 times its EBITDA, which is getting towards the upper limit of our comfort range on a dividend stock that the investor hopes will endure a wide range of economic circumstances.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. With EBIT of 12.87 times its interest expense, Inchcape's interest cover is quite strong - more than enough to cover the interest expense.

Consider getting our latest analysis on Inchcape's financial position here.

Dividend Volatility

One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. The first recorded dividend for Inchcape, in the last decade, was nine years ago. The dividend has been quite stable over the past nine years, which is great to see - although we usually like to see the dividend maintained for a decade before giving it full marks, though. During the past nine-year period, the first annual payment was UK£0.066 in 2011, compared to UK£0.27 last year. Dividends per share have grown at approximately 17% per year over this time.

The dividend has been growing pretty quickly, which could be enough to get us interested even though the dividend history is relatively short. Further research may be warranted.

Dividend Growth Potential

Dividend payments have been consistent over the past few years, but we should always check if earnings per share (EPS) are growing, as this will help maintain the purchasing power of the dividend. Over the past five years, it looks as though Inchcape's EPS have declined at around 21% a year. A sharp decline in earnings per share is not great from from a dividend perspective, as even conservative payout ratios can come under pressure if earnings fall far enough.

Conclusion

Dividend investors should always want to know if a) a company's dividends are affordable, b) if there is a track record of consistent payments, and c) if the dividend is capable of growing. We're not keen on the fact that Inchcape paid out such a high percentage of its income, although its cashflow is in better shape. Earnings per share have been falling, and the company has a relatively short dividend history - shorter than we like, anyway. There are a few too many issues for us to get comfortable with Inchcape from a dividend perspective. Businesses can change, but we would struggle to identify why an investor should rely on this stock for their income.

Given that earnings are not growing, the dividend does not look nearly so attractive. Very few businesses see earnings consistently shrink year after year in perpetuity though, and so it might be worth seeing what the 5 analysts we track are forecasting for the future.

If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 3%.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.