February 22, 2019, wasn’t a particularly memorable day for most investors. But Warren Buffett probably recalls it quite vividly. You would too if you lost $4.3 billion in a matter of hours.

That’s the day Kraft Heinz (NYSE: KHC) stock imploded after the company slashed its quarterly dividend by nearly 40%. Berkshire Hathaway owned 325 million shares. So, when KHC tumbled from $47 to $34 that fateful Friday (a 28% plunge), there wasn’t anyone with more at stake.

The words dividend cut strike fear into the hearts of even the most hardened investor. Not only do they reduce future income, but they also typically trigger capital losses as investors abandon the shares. That’s a painful double-whammy.

Unfortunately, it happens all too often. Just days before Kraft made headlines, the market was stunned by an even sharper 50% dividend reduction from CenturyLink (now Lumen). Management had given investors no advance warning. Quite the opposite, the company had sounded confident in recent commentary and suggested that distributions were on solid financial ground.

So when the news broke, the market’s reaction was swift and brutal. Shares of the telecom provider plummeted to a 20-year low. A dozen Wall Street analysts responded by lowering their price targets.

Too little, too late.

Just 24 hours earlier, the stock offered a towering yield of 15%… the highest in the entire S&P 500. Like moths to a bright light, that lofty payout lured thousands of income seekers, including trusted institutional managers. Unfortunately, that light proved to be a bug zapper.

These aren’t isolated examples. Here are some more recent offenders:

— Leggett & Platt (NYSE: LEG) A reliable supplier of furniture parts and other industrial products, LEG had been steadily raising dividends for over half a century. Until last July, when it was forced to slash quarterly distributions by 90% (from $0.46 to $0.05) to strengthen the balance sheet amid flagging sales and ongoing restructuring efforts.
— Walgreens Boots Alliance (NYSE: WBA) – Struggling with online competition and thin prescription reimbursement, the pharmacy chain cut its dividend in half last year. The other shoe dropped a few months ago when the remaining half was axed to preserve cash and help refinance debt.
— Intel (Nasdaq: INTC) Faced with mounting costs to revitalize its manufacturing operations, the sluggish chipmaker has announced plans to scale back spending, shrink the workforce and suspend its dividend until further notice.
— 3M (NYSE: MMM) Even “Dividend Kings” can fall. The maker of Scotch Tape and countless other products had delivered 64 straight years of dividend hikes before making the difficult decision to reset its payout last year amid legal liabilities and the spinoff of its healthcare unit.

Trust me, these aren’t the last dividend “adjustments” we’ll see. And they can be painful. According to a lengthy study from 1962 to the present, Morgan Stanley found that stocks suffering deep cuts of 25% or more went on to lag the market by an average of 1,200 basis points over the next six months.

So it’s important to look for some of the telltale signs. After all, avoiding a loss is just as important as booking a gain. Sometimes, the best offense is a good defense. With that in mind, you may want to steer clear of stocks exhibiting these symptoms.

Distributions that Outweigh Earnings
A business can’t pay out more than it takes in – at least not for long.

One of the simplest tools to use is the payout ratio, which simply measures dividend distributions as a percentage of earnings. Microsoft (NSDQ: MSFT), for instance, recently dished out a quarterly payment of $0.83 per share, which was supported by a net profit of $3.46

That’s a payout ratio of 24%, meaning the tech giant pays out roughly a quarter for every dollar of net income. If we invert these two figures ($3.46/$0.83), then we get a coverage ratio of 416%, indicating it rakes in more than $4 for every $1 disbursed.

It’s two different ways of expressing the same thing.

The sweet spot for most companies is a payout ratio of around 40% to 60%. Too low, and you probably aren’t getting a good yield. Too high, and the distribution might be on thin ice (especially if earnings slide). Right in the middle leaves wiggle room for downturns — as well as future hikes.

But that’s just a loose rule of thumb.

Keep in mind, some industries commonly pay out more. Real estate investment trusts (REITs) and master limited partnerships (MLPs) must distribute at least 90% of their taxable income to maintain their federal tax-exempt status.

Generally, though, show caution with companies whose payout ratios are near (or above) 100%. They might be able to maintain payments for a while using retained earnings or even debt. But the longer the slump, the more likely it will have to eventually reset payouts at a lower level.

Look for comfortable margins of safety where payments can be maintained even when profits are at low tide.

Poor Cash Flow Conversion
Earnings presented under generally accepted accounting principles (GAAP) are useful but don’t always tell the whole picture. In some cases, they can be downright misleading – either understating or overstating profits.

A company that reports $1.00 per share in quarterly earnings doesn’t necessarily take in $1.00 in operating cash flows after all the bills are paid. It might have pocketed $1.20 that period, or $0.80.

There are numerous non-cash entries that can be added to or subtracted from the bottom-line, even when no money changes hands. They include everything from asset impairment write-downs to stock options compensation.

I use supplemental metrics such as funds from operations (FFO) and distributable cash flow (DCF), which are reconciled with earnings by adding back these non-cash charges. I think they provide a truer picture of a firm’s dividend-paying capacity.

REITs and MLPs incur hefty depreciation and thus routinely generate more cash than net income. But some businesses do the opposite — and are thus less capable of meeting dividends than would first appear.

How could that happen? Easy.

A manufacturer might send a large merchandise order to a retail customer and book it as a sale, but then extend generous credit terms and not collect the revenue until a future period.

Or, it could show a sizeable gain from an open futures trade. The current value of derivative instruments (often used for hedging purposes) must be recorded each quarter, even if the gain/loss is non-realized. That might lead to a profit in 2024, even though the contracts won’t be settled until 2025.

A business can’t pay a dividend with a paper gain any more than we can pay our car note with an unrealized winner in our 401(K) account.

It’s also common for companies to sell off assets and record a gain from the proceeds. It’s a perfectly legitimate transaction. But you can’t count on this money to sustain future dividends. It’s a one-time event. What happens next quarter when there isn’t a sale?

With all this in mind, take a few minutes to familiarize yourself with the cash flow statement, which strips out the impact of one-time gains and losses and reflects the true amount of cash flowing in and out of the business.

Don’t forget to subtract capital expenditures on property, plants and equipment from operating cash flows to get free cash flow (FCF). This is the pool of cash that is used to pay dividends, repurchase shares, or make acquisitions.

If a company has weak (or negative) free cash flows, then you must ask yourself where the money is coming from to continue supporting the dividend.

Excessive Leverage
When wielded properly, debt can be a powerful tool. If a business with a weighted average cost of capital at 5% can deploy the proceeds and earn healthy returns on invested capital (RoIC) of 15%, it makes financial sense to keep borrowing and creating shareholder value.

But leverage can be a double-edged sword. Problems that might not be visible on the income statement lurk on the balance sheet. Too much debt can be dangerous. How much is too much? Unfortunately, there is no specific answer. Financing needs, capital requirements, and other factors vary from industry to industry.

One simple evaluation yardstick is debt-to-EBITDA. A ratio of 4.0 means it would take four years for a company to repay debt (net of cash) using current annualized cash flows. But what’s reasonable for one company might be high for another. You can’t compare an automaker, for example, with a bank.

Credit ratings can give you a good idea of a company’s ability to service its debt. A ratings downgrade indicates that there has been a deterioration in the outlook.

Keep in mind that while debt levels are important, so too are maturity schedules. Two similar companies might each have $1 billion in debt. But suppose one must repay the entire amount in six months, while the other has refinanced and pushed the maturity back to 2029.

All things equal, the first company is riskier. Looming principal payments on the horizon make dividends much less of a near-term priority.

I pay close attention to the current ratio (current assets/current liabilities), a short-term liquidity gauge. If a company has $10 million in cash, accounts receivable and other assets against $5 million in notes payable and other current liabilities, then it has $2 on hand to pay every $1 owed over the next 12 months.

That’s comfortable.

But if those figures are reversed and there is only $0.50 to pay every $1 owed, then you might be looking at a company in financial distress. Lenders keep a close eye on asset coverage ratios – and for good reason.

Also, take a moment to see how much of the debt is at fixed versus variable rates. The latter can become a much heavier burden in a rising rate environment when borrowing costs rise.

Even when debt isn’t a ticking time bomb, it can still decrease flexibility and prevent a company from pursuing expansion projects and acquisitions. Furthermore, restrictive covenants from banks and other lenders control what the borrower can and can’t do (including dividend policy) in the event of a cash crunch.

And when those credit lines are maxed out, cash-strapped organizations often raise funding by issuing new shares, a dilutive act that puts downward pressure on a stock.

The credit markets are often quicker to sniff out trouble. Look to see whether a company’s bonds are trading below par value. Steep discounts suggest bondholders have serious doubts about the company’s ability to meet financial obligations.

Remember, while dividend payments are completely voluntary, loan payments are decidedly not. So if a business is on the ropes, elective payments will be the first to go.

Restructurings and Turnarounds
Just about every company on the planet goes through the occasional slump – even profit powerhouses like Apple (Nasdaq: AAPL). Oil prices are notoriously cyclical, but that hasn’t stopped ExxonMobil (NYSE: XOM) from raising dividends for decades.

So temporary downturns don’t automatically invite dividend cuts. Strong businesses usually have a reserve stockpile of cash for a rainy day and can hunker down in a storm.

But what about sustained market share losses? Or disruptive threats to an entire industry?

Embattled companies can fight back by launching innovative products, tapping into new markets, or finding ways to reinvent themselves. But even if these initiatives work, they are often costly and take time. In the meantime, dividends must often be sacrificed to preserve cash and shore up the balance sheet.

Case in point, softening demand for electric vehicles has driven lithium spot prices to a rock-bottom $12,700 per ton, down from a recent peak of $75,000. This collapse has taken a toll on industry leader Albemarle (NYSE: ALB), leaving earnings in negative territory last quarter.

At current pricing, it will be difficult for the business to achieve breakeven free cash flows. Management is doing what it can, lightening this year’s capital expenditures budget to $0.7 billion, half of the $1.7 billion spent last year. The company is also pivoting into “high return, quick payback” growth projects.

Can it work? Possibly. But in the meantime, sustainability of the firm’s $0.40 quarterly dividend has been called into question.

Don’t Be Blindsided
Dividend cuts rarely come out of left field. They are often preceded by a tumbling share price, which reflects dimmer cash flow prospects, a stressed balance sheet and other market concerns. Double-digit yields, themselves, can be a red flag.

Of course, there are also false alarms, where yields spike, yet the company is successfully able to navigate the downturn and maintain payments. These often turn out to be big winners.

The biggest challenge is differentiating one from the other.

That task is made even harder in situations where a company has the financial resources to continue paying dividends but simply decides that the cash is better spent elsewhere. Identifying these situations is more of a mind reading exercise than a numerical calculation.

I’ve been blindsided by a few of these over the years. But there can be still be clues. They often start with the phrase “re-examining our capital priorities.” That’s code for “we want to do something else with the money.”

It’s usually a signal to run, don’t walk, away.

Dividend cuts aren’t a death sentence for a stock. A company can only pay out a portion of what it earns. If the playing field changes and earnings fall, then distributions must be set at a lower level. And if conditions improve, they can be raised as quickly as they were lowered.

Reductions can even help cure an ailing company (although they are a foul-tasting medicine). While not a positive development, I think the market almost always overreacts.

Still, by monitoring payout ratios, cash flow generation, leverage ratios and industry fundamentals, you can usually avoid stepping on these dangerous landmines.