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Dividend paying stocks like Elecon Engineering Company Limited (NSE:ELECON) tend to be popular with investors, and for good reason - some research suggests a significant amount of all stock market returns come from reinvested dividends. Yet sometimes, investors buy a popular dividend stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

With a 0.4% yield and a nine-year payment history, investors probably think Elecon Engineering looks like a reliable dividend stock. A 0.4% yield is not inspiring, but the longer payment history has some appeal. Some simple analysis can reduce the risk of holding Elecon Engineering for its dividend, and we'll focus on the most important aspects below.

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Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, then the dividend might become unsustainable - hardly an ideal situation. So we need to form a view on if a company's dividend is sustainable, relative to its net profit after tax. In the last year, Elecon Engineering paid out 3.2% of its profit as dividends. We'd say its dividends are thoroughly covered by earnings.

Is Elecon Engineering's Balance Sheet Risky?

As Elecon Engineering 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 measures a company's total debt load relative to its earnings (lower = less debt), while net interest cover measures the company's ability to pay the interest on its debt (higher = greater ability to pay interest costs). Elecon Engineering has net debt of less than two times its earnings before interest, tax, depreciation, and amortisation (EBITDA), which we think is not too troublesome.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. With EBIT of 1.23 times its interest expense, Elecon Engineering's interest cover is starting to look a bit thin.

Consider getting our latest analysis on Elecon Engineering's financial position here.

Dividend Volatility

One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. Looking at the last decade of data, we can see that Elecon Engineering paid its first dividend at least nine years ago. It's good to see that Elecon Engineering has been paying a dividend for a number of years. However, the dividend has been cut at least once in the past, and we're concerned that what has been cut once, could be cut again. During the past nine-year period, the first annual payment was ₹1.50 in 2010, compared to ₹0.20 last year. This works out to a decline of approximately 87% over that time.

We struggle to make a case for buying Elecon Engineering for its dividend, given that payments have shrunk over the past nine years.

Dividend Growth Potential

With a relatively unstable dividend, and a poor history of shrinking dividends, it's even more important to see if EPS are growing. It's good to see Elecon Engineering has been growing its earnings per share at 38% a year over the past 5 years. The company is only paying out a fraction of its earnings as dividends, and in the past been able to use the retained earnings to grow its profits rapidly - an ideal combination.

Conclusion

When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. Firstly, we like that Elecon Engineering has low and conservative payout ratios. We were also glad to see it growing earnings, but it was concerning to see the dividend has been cut at least once in the past. All things considered, Elecon Engineering looks like a strong prospect. At the right valuation, it could be something special.

Are management backing themselves to deliver performance? Check their shareholdings in Elecon Engineering in our latest insider ownership analysis.

We have also put together a list of global stocks with a market capitalisation above $1bn and yielding more 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.