Dear Valued Visitor,

We have noticed that you are using an ad blocker software.

Although advertisements on the web pages may degrade your experience, our business certainly depends on them and we can only keep providing you high-quality research based articles as long as we can display ads on our pages.

To view this article, you can disable your ad blocker and refresh this page or simply login.

We only allow registered users to use ad blockers. You can sign up for free by clicking here or you can login if you are already a member.

Where Next for the RSA Insurance Group plc (RSA) 7% Dividend?

LONDON — Many investors focus on earnings per share when judging a company’s performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don’t tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn’t necessarily mean the payout is actually being funded from a company’s profits.
A company’s cash flow can tell you a lot about a firm’s financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn’t funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.

In this series, I’m going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I’m looking at RSA Insurance Group plc (LON:RSA), the 300 year-old general insurance company previously known as Royal Sun Alliance.

Does RSA have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that’s left over after capital expenditure, interest payments, and tax deductions. With that in mind, let’s look at RSA’s cash flow from the last 4.5 years:

Year 2008 2009 2010 2011 H1 2012
Free cash flow (£m) 81 -294 411 285 331
Dividend payments (£m) 189 198 248 321 202
Free cash flow/dividend* 0.4 -1.5 1.7 0.9 1.6

Source: RSA Insurance Group results. *A value of >1 means the dividend was covered by free cash flow.

Aviva PlcRSA’s cash flow statements provide a good example of how a dividend can be reliably covered by earnings, but not by cash flow. By my calculation, RSA’s dividends have only been covered by free cash flow an average of 0.6 times over the last 4.5 years, meaning that 40 pence of every pound paid in dividends has come from cash reserves or borrowed funds.

Although this isn’t something I like to see in a company, in RSA’s case it isn’t too alarming, since the company has maintained a cash balance of greater than 1 billion pounds throughout this period. What’s more, judging from its 2012 half-yearly report, this insurance giant generated cash strongly last year, as its cash balance rose by 135 million pounds to 1,376 million pounds during the first half of 2012.

A 7% dividend yield?
Now we’ve established that RSA can comfortably afford its dividend payments, we need to question why its 7% yield is so high — after all, it’s more than double the 3.3% average of the FTSE 100. The short answer is that since it peaked in 2007, RSA’s share price has drifted downwards to a low of about 98 pence in June 2012, thanks to a combination of falling profits and the effects of the eurozone crisis.