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Dividend paying stocks like Tata Steel Limited (NSE:TATASTEEL) tend to be popular with investors, and for good reason - some research suggests a significant amount of all stock market returns come from reinvested dividends. If you are hoping to live on the income from dividends, it's important to be a lot more stringent with your investments than the average punter.

A 2.6% yield is nothing to get excited about, but investors probably think the long payment history suggests Tata Steel has some staying power. Some simple analysis can offer a lot of insights when buying a company for its dividend, and we'll go through this below.

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Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, then the dividend might become unsustainable - hardly an ideal situation. So we need to form a view on if a company's dividend is sustainable, relative to its net profit after tax. In the last year, Tata Steel paid out 15% of its profit as dividends. We like this low payout ratio, because it implies the dividend is well covered and leaves ample opportunity for reinvestment.

Is Tata Steel's Balance Sheet Risky?

As Tata Steel has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick way to check a company's financial situation uses these two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments on debt. Essentially we check that a) a company does not have too much debt, and b) that it can afford to pay the interest. With net debt of above 3x EBITDA, investors are starting to take on a meaningful amount of risk, should the business enter a downturn.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Interest cover of less than 5x its interest expense is starting to become a concern for Tata Steel, and be aware that lenders may place additional restrictions on the company as well.

Remember, you can always get a snapshot of Tata Steel's latest financial position, by checking our visualisation of its financial health.

Dividend Volatility

From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. Tata Steel has been paying dividends for a long time, but for the purpose of this analysis, we only examine the past 10 years of payments. Its dividend payments have fallen by 20% or more on at least one occasion over the past ten years. During the past ten-year period, the first annual payment was ₹16.00 in 2009, compared to ₹13.00 last year. This works out to be a decline of approximately 2.1% per year over that time. Tata Steel's dividend hasn't shrunk linearly at 2.1% per annum, but the CAGR is a useful estimate of the historical rate of change.