Readers hoping to buy McGrath Limited (ASX:MEA) for its dividend will need to make their move shortly, as the stock is about to trade ex-dividend. Typically, the ex-dividend date is one business day before the record date which is the date on which a company determines the shareholders eligible to receive a dividend. It is important to be aware of the ex-dividend date because any trade on the stock needs to have been settled on or before the record date. Thus, you can purchase McGrath's shares before the 28th of February in order to receive the dividend, which the company will pay on the 23rd of March.

The upcoming dividend for McGrath is AU$0.025 per share, increased from last year's total dividends per share of AU$0.02. If you buy this business for its dividend, you should have an idea of whether McGrath's dividend is reliable and sustainable. We need to see whether the dividend is covered by earnings and if it's growing.

View our latest analysis for McGrath

Dividends are typically paid out of company income, so if a company pays out more than it earned, its dividend is usually at a higher risk of being cut. McGrath has a low and conservative payout ratio of just 19% of its income after tax. Yet cash flows are even more important than profits for assessing a dividend, so we need to see if the company generated enough cash to pay its distribution. The good news is it paid out just 9.5% of its free cash flow in the last year.

It's positive to see that McGrath's dividend is covered by both profits and cash flow, since this is generally a sign that the dividend is sustainable, and a lower payout ratio usually suggests a greater margin of safety before the dividend gets cut.

Click here to see how much of its profit McGrath paid out over the last 12 months.

Have Earnings And Dividends Been Growing?

Stocks in companies that generate sustainable earnings growth often make the best dividend prospects, as it is easier to lift the dividend when earnings are rising. If earnings decline and the company is forced to cut its dividend, investors could watch the value of their investment go up in smoke. This is why it's a relief to see McGrath earnings per share are up 4.5% per annum over the last five years. Growth has been anaemic. Yet with more than 75% of its earnings being kept in the business, there is ample room to reinvest in growth or lift the payout ratio - either of which could increase the dividend.

Another key way to measure a company's dividend prospects is by measuring its historical rate of dividend growth. McGrath's dividend payments per share have declined at 8.9% per year on average over the past six years, which is uninspiring. McGrath is a rare case where dividends have been decreasing at the same time as earnings per share have been improving. It's unusual to see, and could point to unstable conditions in the core business, or more rarely an intensified focus on reinvesting profits.