Personal finance

3 measures to use to avoid falling into dividend traps | Personal finance

A company that generates more free cash flow than it pays out in dividends is good for investors. On the other hand, if a company pays out more dividends than it generates in free cash flow, that’s a red flag. Not only can a lack of free cash flow be a concern right now, it also calls into question a company’s ability to continue paying (or increasing) its dividend in the future.

3. Debt ratio

The debt ratio measures the proportion of a company’s operations financed by debt compared to equity. You can find it by dividing its total liabilities by total equity. A low debt ratio means that a company’s operations are financed more with equity than with debt. A high debt-to-equity ratio means a company obtains more of its financing through debt, which is considered riskier.

While a high dividend yield is intriguing, investors should know how the company manages to pay the dividend it pays. If a company takes on a lot of debt to maintain its dividend payments, this should be seen as a red flag. In corporate structures, companies have a higher obligation to repay debts than to pay dividends. So, if a company finds itself in financial difficulty or heading for bankruptcy, it is likely that investors will see their dividends completely reduced.