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 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 dividend favorite National Grid  , which operates the U.K.'s electricity and gas transmission networks and provides electricity direct to customers in its license areas in the northeastern United States.


Does National Grid 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 National Grid's cash flow from the last five years:

Year

2008

2009

2010

2011

2012

Free cash flow (£m)

(758)

354

1,181

(881)

1,108

Dividend payments (£m)

780

838

688

858

1,006

Free cash flow/dividend*

(1.0)

0.4

1.7

(1.0)

1.1

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

National Grid's free cash flow and dividend payments don't seem well matched; its free cash flow has failed to cover its dividend payments in three of the last five years. The company's interest payments have also exceeded its dividend payments several times and both interest and dividend payouts have only been affordable through continued increases in debt, along with a £3.2 billion rights issue in 2010.

This suggests that National Grid may be at risk of living beyond its means -- but the situation should become clearer in the next few months, as I explain below.

Regulated income
As a regulated utility, National Grid operates under long-term agreements with Ofgem, its U.K. regulator. These agreements define how much it is allowed to charge its customers and how much it is required to invest in its networks -- effectively, Ofgem decides how much profit National Grid will be allowed to make.

National Grid's current deals expire at the end of March and the company is currently in the middle of negotiating a new set of proposals with Ofgem, known as RIIO-T1 and RIIO-GD1. These cover the company's U.K. electricity and gas transmission networks respectively, and will run from April 1, 2013, until March 31, 2021. The details are still being negotiated and National Grid doesn't expect to agree (or disagree) with Ofgem's most recent proposals until early in March.

Once these proposals have been agreed, then National Grid will go public with a new dividend policy. I cannot see how the company can maintain its recent 8% annual dividend growth policy, which expired in March 2012, especially as Ofgem's proposals have not been as generous as National Grid had hoped. A more modest rate of increase is almost inevitable, and in my view, a good outcome would be an extension of National Grid's current 4% dividend growth policy.

A more realistic outcome might be for the dividend to be linked to inflation or even held -- National Grid really doesn't have the cash to be splurging on above-inflation dividend growth.

Is National Grid's dividend safe?
If National Grid manages to agree its new pricing and spending proposals with Ofgem by April, then the firm should reveal a new dividend policy when it publishes its full-year results in May. However, there is a risk that National Grid and Ofgem won't be able to reach a deal, in which case the proposals will be referred to the Competition Commission, which could results in many months of further delay and uncertainty.

To sum up, there's no doubt that National Grid will continue to offer an above-average dividend yield, but the firm's ability to grow its dividend over the next few years will be limited. I think National Grid will manage some kind of dividend increase each year, but I don't think it will rise much ahead of inflation.

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 National Grid's Dividend? originally appeared on Fool.com.

Roland Head has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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