The payout ratio is simply a way to figure out what percentage of the company’s earnings are being paid out in the form of dividends. People concerned about the safety of their dividend income should regularly watch the payout ratio. Generally, a dividend payout ratio of 60 percent or less is safe. Obviously, the lower the percentage is, the safer the dividend.

Say that the company Urn More Corp. (UMC) has annual earnings of $1 million dollars. Total dividends of $500,000 are to be paid out, and the company has 1 million outstanding shares. Using those numbers, you know that UMC has earnings per share (EPS) of $1.00 ($1 million in earnings divided by 1 million shares) and that it pays an annual dividend of 50 cents per share ($500,000 divided by 1 million shares).

The dividend payout ratio is 50 percent (the 50 cents dividend is 50 percent of the $1.00 EPS). This is a healthy dividend payout ratio because even if the company’s earnings were to fall by 10 percent or 20 percent, it would still have plenty of room to pay dividends.

Keep in mind that a company’s earnings aren’t necessarily cash. Looking at cash flow from operations versus earnings is another way to measure dividend safety.