According to the Oxford English Dictionary, a dividend is, "a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves)."
Historically, it has been shown that dividends have been integral in providing returns to investors (Global Investment Returns Yearbook). However, dividends fall considerably down the ‘pecking order’ in the distribution of corporate earnings, lying behind capital expenditure and other investments. As such, it is important to understand a firm’s capital structure and financing decisions in order to ascertain whether a company can maintain its dividend policy over the long term.
In looking at a company’s dividend-paying profile, investors should scrutinise how the dividends were paid. Did the company’s cash levels rise, or did debt levels grow in line with dividend increases? And if cash levels did grow, was this attributable to increased revenues or a one off favourable adjustment? Was there also investment in capital expenditures to maintain and grow the business? All of these are important questions. Ideally, a firm will have some capital expenditure so that it may re-invest for growth, but the appropriate level of such expenditure will depend on the type of business it operates. It should also be possible to pay dividends out of current cash flows and not fund them through debt over the long term. Finally, the dividend cover ratio, or the amount of cash over and above the dividend payment available, should leave a margin of safety. Again, this ratio will differ from one type of business to another. This is not an exhaustive list of the considerations, but should help investors establish whether or not a firm is able to sustain long-term dividend payments.