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 taking a look at the cash flow statements of some of the biggest names in the FTSE 100 (UKX) to see whether they can afford to pay dividends from their free cash flow. Today, I'm going to take a look at Royal Bank of Scotland Group -- after four years without dividends, can it now afford to restart dividend payments?

The story so far
After nearly collapsing during the financial crisis, RBS was bailed out by the government, which continues to hold 82% of the shares in this 285-year old bank. As the bank faced a massive pre-tax loss of 25 billion pounds in 2008, dividends were cancelled -- and that has been the situation ever since. Over the last three years, RBS' losses have narrowed, and last year its pre-tax loss was just 766 million pounds. This year, RBS is expected to return to profit, and according to Morningstar, the consensus forecast among brokers is for pre-tax profits of around 3.5 billion pounds.


The big question for shareholders is whether the company's final results will include a dividend declaration. I've had a look at the company's cash flow statements to see if there are any clues.

Does RBS 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. RBS hasn't had much free cash flow in recent years -- but is that changing now that its business is returning to normal?

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 RBS' cash flow from the last four and a half years:

Year20082009201020112012
(first half)
Free cash flow* -60,308 -2,684 22,003 2,625 1,550
Pre-tax profits* -25,691 -2,647 -399 -766 -1,505
Cash/cash equivalents at period end* 134,925 144,186 152,530 152,655 151,097

Source: RBS Group company reports. *In millions of pounds.

Can RBS afford a dividend?
RBS is on the road to recovery, but it has not arrived yet. The bank has reduced its balance sheet by 700 biilion pounds since 2007 by divesting non-core assets, cut its dependence on short-term wholesale funding, and improved its Core Tier 1 ratio, which has risen from 4% in 2008 to 10.3% in June this year.

In April 2010, the European Union banned RBS from paying dividends until April 2012, as a condition of its state aid deal. Since April, RBS has resumed dividend payments on preference shares but has yet to restart dividend payments on ordinary shares. The most recent comment on dividends came from RBS Chief Executive Stephen Hester. In a speech to fellow bank bosses at a conference organized by Merrill Lynch, he said that the bank was planning on resuming dividends after 2013 as part of its plan to return the bank to private sector ownership. Assuming things continue to go to plan, I interpret this to mean that RBS will declare a dividend in its 2013 final results, which will be paid in 2014.

I believe that RBS shareholders are likely to have to wait at least another 18 months before any dividend payments arrive in their sharedealing accounts, but RBS' recovery definitely appears to be making good progress and a dividend is now a realistic possibility. It wasn't so long ago that investors were wondering whether the bank could survive at all.

Top income tips
One man who was smart enough to get out of banking shares before they crashed is legendary City fund manager Neil Woodford. Woodford is a dividend specialist whose High Income fund grew by 342% over the 15 years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%.

Woodford selects stocks that he believes are undervalued and likely to deliver strong dividend growth. His record is one of the best in the City and at the end of October 2012, he had 21 billion pounds of private investors' funds under management -- more than any other City fund manager.

You can learn about eight of Neil Woodford's largest holdings and how he generates such fantastic returns in this exclusive Motley Fool report. It's completely free, but is available for a limited time only. I strongly suggest you click here and download the report today to avoid missing out.

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The article Where Next for RBS' Dividend Hopes? originally appeared on Fool.com.

Roland does not own shares in any of the companies mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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