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Is Biofactory S.A. (WSE:BFC) a good dividend stock? How would you know? Dividend paying companies with growing earnings can be highly rewarding in the long term. On the other hand, investors have been known to buy a stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

Some readers mightn't know much about Biofactory's 2.8% dividend, as it has only been paying distributions for the last two years. Many of the best dividend stocks typically start out paying a low yield, so we wouldn't automatically cut it from our list of prospects. The company also bought back stock equivalent to around 67% of market capitalisation this year. That said, the recent jump in the share price will make Biofactory's dividend yield look smaller, even though the company prospects could be improving. When buying stocks for their dividends, you should always run through the checks below, to see if the dividend looks sustainable.

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Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable - hardly an ideal situation. So we need to be form a view on if a company's dividend is sustainable, relative to its net profit after tax. In the last year, Biofactory paid out 35% of its profit as dividends. A medium payout ratio strikes a good balance between paying dividends, and keeping enough back to invest in the business. Besides, if reinvestment opportunities dry up, the company has room to increase the dividend.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Biofactory's cash payout ratio last year was 19%, which is quite low and suggests that the dividend was thoroughly covered by cash flow. It's positive to see that Biofactory'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.

Is Biofactory's Balance Sheet Risky?

As Biofactory 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.