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 (UKX), to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at oil supermajor BP  , a former dividend stalwart whose record of reliable payouts was smashed by its Gulf of Mexico oil spill in 2010. BP's forecast payout for 2012 is just 60% of its 2009 payout, but what does the future hold for BP shareholders?


BP's sale of the century
After the disastrous events of 2010, BP started selling non-core assets to raise funds to cover the clean-up costs, legal fees, fines and damages that would soon start coming its way. By the end of 2012, it had raised $37.8 billion of the $42 billion it expects to need, most of which has already been allocated. Although this huge liability would have been enough to cripple most companies, BP's large asset base and bumper 2011 revenues from high oil prices have enabled it to manage the situation successfully and return to profitability -- broker consensus estimates are for a pre-tax profit of £17.5 billion in 2012.

I think that the biggest remaining threat to the safety of BP's dividend is its upcoming U.S. trial for violations of the Clean Water Act. BP is hoping for a finding of negligence, which will carry a manageable fine of around $5 billion. However, there is a possibility BP will be found guilty of gross negligence, which would carry a fine of up to $21 billion. Should this happen, BP's finances would come under serious pressure and its dividend could be threatened once more.

That trial starts on Feb. 25, and we'll be covering the outcome here as soon as it's announced -- but in the meantime, it's worth looking at BP's recent track record of dividend payments.

Does BP 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 BP's cash flow from the last five years:

Year

2007

2008

2009

2010

2011

Free cash flow ($m)

9,872

15,328

9,583

9,656

(4,479)

Dividend payments ($m)

8,333

10,767

10,899

2,942

4,317

Free cash flow/dividend*

1.2

1.4

0.9

3.3

(1.0)

Source: BP annual reports. * A value of >1 means the dividend was covered by free cash flow.

The period from 2007-2009 represented business as usual for the old BP, and it's clear that the company's free cash flow provided a decent level of coverage for its generous dividends. Since then, BP's cash flow has been distorted by its divestment and restructuring program, but underlying net cash from operating activities -- the income from its ongoing operations -- has remained strong, thanks to a sustained period of high oil prices.

Is BP's dividend safe?
BP raised its quarterly dividend by 12.5% in the third quarter of last year, following a 40% rise in underlying earnings. The move was an attempt to win back the support of institutional investors, but the reality is that BP is still a company in transition.

In a worst-case scenario, BP could be hit by a $21 billion fine from its Clean Water Act court case and by falling oil prices at the same time. Such a scenario would hit the company hard and would threaten its dividend, making it vulnerable to a takeover bid. However, I don't think this will happen. I expect to see Brent Crude stay above $100 per barrel and I think that a lower fine for negligence, or even a settlement before the case reaches court in February, is much more likely.

Overall, I think that BP's dividend looks reasonably safe, but is unlikely to grow significantly over the next couple of years.

Top income tips
One man who really understands how to assess the quality of a company's dividends is legendary City fund manager Neil Woodford, 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%.

Mr. 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 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 BP's Dividend originally appeared on Fool.com.

Roland Head has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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