Are these 10 big dividend blue-chips in danger?

Shares in publishing group Pearson plunged 30% last week (18 January) on the back of the firm issuing a profit warning and taking the axe to its dividend payout.

It is the latest heavyweight name in the FTSE 100 to cut its dividend over the past couple of years - and be punished for doing so. When banking giants Barclays and Santander announced cuts (in March 2016 and January 2015 respectively) the shares similarly tanked by double-digit percentages.

There are, however, ways for private investors to detect when a dividend cut may be on the horizon. But it is worth adding the caveat that some cuts can come completely out of nowhere; one such example is when there's a left-field regulatory crackdown of some sort on a particular sector.

Below we name some of the main warning signs that point to a dividend in danger.

High dividend yield

A high dividend yield looks attractive on paper, but it is should be treated with a healthy dose of scepticism. As share prices and yields have an inverse relationship, a high yield more often than not is a sign that a stock for whatever reason is out of favour.

It is therefore crucial to do some digging to check whether the yield on offer is sustainable. One of the first things to look for is the company's track record for paying dividends.

Although a stock that has been a generous payer in the past should not be considered a sure bet for dividends continuing to roll in, those businesses that have patchy records or have historically been poor payers should be cause for alarm bells ringing.

Dividend cover

This is considered a key metric to assess whether a company is in a healthy position to distribute dividends. It is calculated by dividing earnings per share (EPS) by the dividend per share (DPS).

As a rule of thumb, a low dividend cover score - around one times or lower - suggests dividends are vulnerable, as the company is using most if not all of its profits to fund the dividend. A figure of two or more is viewed as comfortable because it is a sign the business is not over distributing.

Those firms that do hand back more cash than they can afford risk damaging their longer-term growth prospects through lack of investment in the business.

Debt levels on the rise

Another warning sign is when the dividend is being funded out of debt. One way private investors can work this out is by looking at the free cash flow measure, which takes into account how much money a company has left over once all business expenses have been made, including interest on borrowings.

Those businesses that pay their dividends without resorting to borrowing will have a positive free cash flow figure.

But bear in mind that a negative score does not always mean the dividend is under threat. If money is borrowed cleverly and efficiently, the business will ultimately become more profitable.

Return on capital employed

While there are many ways to assess the strength of a business, arguably one of the most useful is the measure return on capital employed (ROCE), which can be calculated from a company's accounts. The ROCE is the profit figure divided by the assets of the businesses.

Warren Buffett is a fan, describing the measure in 1979 as "the primary test of managerial economic performance". ROCE is considered more useful than the more familiar return on equity measure, because ROCE also factors in debt and other liabilities.

There's no golden number that dictates what a good or bad figure is; instead investors should look at whether the ROCE is rising or falling versus its historical value for that company.

But Terry Smith, manager of the fund Fundsmith Equity, a Rated Fund on our sister website Money Observer, does not consider investing in a company unless it can achieve a ROCE of more than 15%.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.