Today we'll take a closer look at Cardinal Energy Ltd. (TSE:CJ) from a dividend investor's perspective. Owning a strong business and reinvesting the dividends is widely seen as an attractive way of growing your wealth. If you are hoping to live on the income from dividends, it's important to be a lot more stringent with your investments than the average punter.

With a five-year payment history and a 4.2% yield, many investors probably find Cardinal Energy intriguing. It sure looks interesting on these metrics - but there's always more to the story . There are a few simple ways to reduce the risks of buying Cardinal Energy for its dividend, and we'll go through these below.

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Payout ratios

Companies (usually) pay dividends out of their earnings. If a company is paying more than it earns, the dividend might have to be cut. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. In the last year, Cardinal Energy paid out 64% of its profit as dividends. This is a fairly normal payout ratio among most businesses. It allows a higher dividend to be paid to shareholders, but does limit the capital retained in the business - which could be good or bad.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Cardinal Energy paid out 203% of its free cash last year. Cash flows can be lumpy, but this dividend was not well covered by cash flow. Paying out more than 100% of your free cash flow in dividends is generally not a long-term, sustainable state of affairs, so we think shareholders should watch this metric closely. Cardinal Energy paid out less in dividends than it reported in profits, but unfortunately it didn't generate enough free cash flow to cover the dividend. Were it to repeatedly pay dividends that were not well covered by cash flow, this could be a risk to Cardinal Energy's ability to maintain its dividend.

Is Cardinal Energy's Balance Sheet Risky?

As Cardinal Energy has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick way to check a company's financial situation uses these two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments on debt. Essentially we check that a) a company does not have too much debt, and b) that it can afford to pay the interest. With net debt of more than twice its EBITDA, Cardinal Energy has a noticeable amount of debt, although if business stays steady, this may not be overly concerning.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Net interest cover of 7.71 times its interest expense appears reasonable for Cardinal Energy, although we're conscious that even high interest cover doesn't make a company bulletproof.

Remember, you can always get a snapshot of Cardinal Energy's latest financial position, by checking our visualisation of its financial health.

Dividend Volatility

From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. Looking at the data, we can see that Cardinal Energy has been paying a dividend for the past five years. During the past five-year period, the first annual payment was CA$0.65 in 2014, compared to CA$0.12 last year. Dividend payments have fallen sharply, down 82% over that time.

Dividend Growth Potential

The other half of the dividend investing equation is evaluating whether earnings per share (EPS) are growing. Over the long term, dividends need to grow at or above the rate of inflation, in order to maintain the recipient's purchasing power. Over the past five years, it looks as though Cardinal Energy's EPS have declined at around 30% a year. If earnings continue to decline, the dividend may come under pressure. Every investor should make an assessment of whether the company is taking steps to stabilise the situation.

We'd also point out that Cardinal Energy issued a meaningful number of new shares in the past year. Regularly issuing new shares can be detrimental - it's hard to grow dividends per share when new shares are regularly being created.

Conclusion

To summarise, shareholders should always check that Cardinal Energy's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. First, we think Cardinal Energy has an acceptable payout ratio, although its dividend was not well covered by cashflow. Earnings per share have been falling, and the company has a relatively short dividend history - shorter than we like, anyway. There are a few too many issues for us to get comfortable with Cardinal Energy from a dividend perspective. Businesses can change, but we would struggle to identify why an investor should rely on this stock for their income.

Without at least some growth in earnings per share over time, the dividend will eventually come under pressure either from costs or inflation. Businesses can change though, and we think it would make sense to see what analysts are forecasting for the company.

Looking for more high-yielding dividend ideas? Try our curated list of dividend stocks with a yield above 3%.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.