We penalise companies which are unable to cover their dividends with free cash flows. In other words, they are financing dividends through debt issuance. Around 64% of the 16,000 companies in our global sample paid a dividend between 2010 and 2015. The median average free cash inflow after deducting dividends equated to 1% of sales. In other words, most companies pay dividends out of free cash flows. Asset heavy sectors with recurring cash flows, such as electricity utilities, are more likely to pay dividends out of free cash outflows than asset light sectors, such as software and media.
Our accounting screen is set to trigger a red flag when free cash flows less dividends/sales turns negative which happens to be the lowest 45th percentile relative to global peers. We also raise red flags when there is an abnormally large decrease relative to the normal rate of change amongst industry peers over one and three years. This latter red flag is triggered when the decrease in free cash flows less dividends is in the 20th lowest percentile relative to the change experienced by industry peers between 2010 and 2015. For scoring purposes we reverse the percentile.