Identifying High-Risk Dividend Stocks Before They Cut Payouts

Investors seeking income often gravitate toward dividend-paying stocks, but not all such investments are created equal. A growing number of companies have slashed or suspended dividends in recent years, leaving shareholders with unmet expectations and eroded trust. To avoid these "dividend traps," investors must scrutinize financial metrics and business fundamentals that signal unsustainable payouts.

The Payout Ratio: A Critical Warning Sign

The payout ratio—the percentage of earnings distributed as dividends—is a foundational metric for assessing dividend sustainability. Companies with ratios exceeding 100% are paying out more in dividends than they earn, a red flag for future cuts. For example, Walgreens Boots Alliance was paying out nearly 300% of its earnings before its 2024 dividend reduction, a clear indicator of overreliance on debt or declining profitability [1].

However, payout ratios alone are not foolproof. Bayer, for instance, maintained a low payout ratio but still cut its dividend significantly in 2025 to fund strategic priorities, underscoring the importance of broader capital allocation decisions [2].

Free Cash Flow: The Unsung Hero of Dividend Health

Free cash flow (FCF) is the lifeblood of dividend sustainability. Companies that fail to generate consistent FCF are often forced to reduce payouts, even if their payout ratios appear healthy. This was evident in the 2025 wave of dividend cuts, where firms with weak FCF faced pressure from creditors and shareholders to prioritize liquidity over dividends [2].

Economic Moat and Competitive Position

A company’s economic moat—its ability to maintain profitability in competitive markets—also plays a pivotal role. Firms with narrow or no moat, such as Walgreens, are more vulnerable to margin compression and operational challenges, increasing the risk of dividend cuts [1]. Conversely, companies with strong moats, like consumer staples or utilities, are better positioned to weather economic downturns while maintaining payouts.

Distance to Default: Quantifying Financial Fragility

Quantitative measures like distance to default—a statistical assessment of a company’s financial health—can further refine risk assessments. Firms with weak scores in this metric are more likely to face dividend reductions, as they struggle to meet debt obligations or navigate volatile markets [1]. This metric becomes especially critical in high-interest-rate environments, where debt servicing costs can spiral out of control [3].

The Interplay of Risks and Strategic Priorities

Dividend cuts are rarely isolated events. They often stem from a confluence of factors: weak earnings, high debt, integration challenges post-merger, or unfavorable macroeconomic conditions. For instance, the 2025 cuts were frequently linked to companies grappling with rising interest rates and integration costs, which strained cash flows and forced difficult capital allocation choices [2].

Actionable Insights for Investors

To avoid dividend traps, investors should:
1. Scrutinize payout ratios above 80% with skepticism, especially in volatile industries.
2. Analyze free cash flow trends to ensure consistent generation over time.
3. Assess economic moat strength to gauge long-term competitive advantages.
4. Monitor distance to default scores for early signs of financial fragility.

By combining these metrics with a deep understanding of a company’s strategic priorities, investors can better navigate the risks of dividend cuts and focus on sustainable income opportunities.

**Source:[1] [Not All Dividend Stocks Are Safe. Here's How to Avoid ...] [https://www.morningstar.com/stocks/not-all-dividend-stocks-are-safe-heres-how-avoid-dividend-traps][2] [97% of dividend cuts caught in advance] [https://www.simplysafedividends.com/dividend-safety-scores/track-record][3] [The financial health of a company and the risk of its default] [https://www.sciencedirect.com/science/article/pii/S1057521924003818]