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FCF payout ratio: is the dividend covered by cash flow?

Definition of the FCF payout ratio (dividends / free cash flow), its formula, where to find its parts in an annual report, usual thresholds, traps and the sectors it does not suit.

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Definition

The FCF payout ratio divides dividends paid by free cash flow (FCF). It shows whether the company pays its dividend with the cash its business generates, once its investments are made, or whether it has to dip into its cash or borrow. It is a stricter check than the payout ratio calculated on accounting profit.

Formula

FCF payout ratio = dividends paid / (operating cash flow − purchases of property, plant, equipment and intangibles)

Where to find it in an annual report

All three amounts are in the cash flow statement: operating cash flow at the top, capital spending in investing activities, and dividends paid to the parent’s shareholders in financing activities.

Common thresholds

Growing dividend: 60% at most for green, up to 80% for orange, red above. A year above 100% can be explained by a large one-off investment. Several years in a row above 100% signal a dividend funded by debt or reserves.

In the preset strategies

Preset strategy Criterion met To monitor Criterion not met
Growing dividend FCF payout ratio (dividends / FCF) ≤ 60% 60% to 80% > 80%

Pitfalls

  • FCF varies a lot from one year to the next: look at the average over 3 to 5 years rather than a single year.
  • Only count dividends paid to the parent’s shareholders, not those paid to minority shareholders of subsidiaries.
  • A dividend paid partly in shares reduces the cash dividends paid, and therefore the FCF payout ratio, at the cost of dilution.
  • Investments postponed to support the dividend improve the ratio in the short term and weaken it afterwards.

Where it does not apply

  • Banks and insurers: FCF makes no sense there, so payouts are judged on earnings and on solvency ratios.
  • Real estate companies: their property acquisitions are growth investments, so the payout is rather measured on operating cash flow.

A worked example

A fictitious company, called Company T here, generates €200 million of operating cash flow, invests €80 million and pays €90 million in dividends. Its FCF is €120 million and its FCF payout ratio 90 / 120 = 75%: orange for the Growing dividend preset strategy.

Payout ratio and FCF payout ratio together

If the payout ratio on earnings is 50% but the FCF payout ratio is 110%, earnings are not turning into cash. The gap often comes from growing inventory or receivables, or from capital spending heavier than depreciation. The FCF conversion entry explains this gap in detail.

Sources