The payout ratio is a common metric that investors study to try to analyze a company’s dividend outlook. The formula is straight forward: divide the dividend paid by net income. It seems to make a lot of sense.

The better a company’s profits cover its dividend obligation, the more likely it should be able to pay out the same dividend, or increase it, in the future. One of the surest ways to build wealth (and protect your portfolio) over the long term is to invest in stocks with demonstrable dividend growth.

WATCH THIS VIDEO: Reader Letters. Answered

A high payout ratio is a warning sign. It means that a company is paying out a big chunk of its earnings to shareholders. This could mean less room for dividend growth or that the current dividend level is unsustainable.

Earnings Not the Same as Cash

However, it’s very important to realize that earnings as reported on the income statement is not a perfect reflection of how well a company can cover its dividend. After all, a company pays out dividend in cash, which is not the same as earnings.

You see, U.S. companies report their financial results under GAAP (generally accepted accounting principles) rules, which require the use of the accrual accounting method.

Consider the following simple scenarios as an illustration of why this matters.

Company A buys 10 office chairs from Company B for $10,000 and pays for the whole thing on the day of purchase. This is straight forward as Company B receives the cash at the same time that it records the sale. No problem here.

But imagine that instead of paying right away, Company A buys the computers on credit and will pay for them at a later time. Under GAAP rules, Company B has to record the revenue on the date of the sale even though it hasn’t received the money. Ideally, Company A will pay off 100% of what it owes Company B, but it’s also possible that it never fully pays the entire $10,000.

Under the second scenario, Company B would show $10,000 in revenue, and the profit/loss calculation would be based off this $10,000 figure. Let’s say its total costs were $8,000, so its profit would be $2,000. But in reality, it does not yet have any cash. So imagine you were basing your dividend expectations solely on that $2,000 accounting profit!

Accounting Decision Can Muddle Picture

Obviously, the simple example is not realistic because a real-world company wouldn’t be relying on only one sale and it would have access to financing to meet its cash needs, and so forth. But the point is that earnings figures can be misleading because they don’t always accurately reflect the financial shape of a company.

In real life, companies have some flexibility when they recognize revenue and expenses. For example, in multi-million-dollar deals involving complex projects that span years, when to recognize revenue and expenses is not always straightforward. A company’s decision can significantly impact its financial numbers. It’s not unheard of for a company to be aggressive in recognizing revenue to make quarterly reports look better to shareholders.

Another common management decision that can materially create distortions between earnings and cash flow is which inventory accounting method to use.

U.S. GAAP gives companies the freedom to choose whether to use the FIFO (first in, first out) or LIFO (last in, last out) method in accounting for the value of their inventory.

FIFO? LIFO?

Let’s go back to the example of the office chairs to show the difference between FIFO and LIFO accounting. Say Company B has 1,000 identical chairs in stock, and 500 of them were bought one year ago at $50, and the other 500 were bought six months ago at $75. If Company B sells 500 chairs from inventory, under FIFO the 500 chairs purchased one year ago at $50 would be considered sold. Under LIFO it would be the 500 units bought six months ago at $75.

In the first case, the cost of goods sold would be $25,000 ($50 x 50) and the value of the remaining inventory would be $37,500. But under LIFO, the cost of goods sold would be $37,500 and the value of the remaining inventory would be $25,000.

Even though Company B would receive the same amount of cash for the sale of the chairs under FIFO or LIFO, the expenses (and thus profit) would actually be different!

It should be clear now that a company’s earnings does not tell the full picture. This does not mean that the payout ratio is useless. Quite the contrary. It is still a helpful ratio to check out, especially if you compare it with those of the company’s peers and compare it to the company’s own history. The point, though, is that you should not look at the payout ratio in isolation. It’s a good starting point, but you have to study a company’s numbers more closely to truly get a good picture of where it stands.

Editor’s Note: Scott Chan just provided you with invaluable investing advice, especially if your focus is on income-paying stocks.

If you’re looking for new sources of income, you also should consider our premium trading service, Rapier’s Income Accelerator, helmed by our income expert Robert Rapier.

Robert Rapier can show you how to squeeze up to 18 times more income out of dividend stocks, with just a few minutes of “work” each week. Click here for details.