Chartered Financial Analyst Level 2

Explanation

Option A: Dividends being financed by new debt - This is the correct answer because:

• When a company uses new debt to pay dividends, it indicates that its operating cash flows are insufficient to cover dividend payments
• This creates a dependency on external financing rather than sustainable internal cash generation
• It signals potential financial distress and inability to maintain dividend payments long-term

Option B: Dividend yield at the lowest historical level - This is not necessarily a negative signal:

• Low dividend yield could simply mean the stock price has increased significantly
• It doesn't directly indicate sustainability issues with the dividend itself

Option C: Dividend coverage ratio consistently increasing - This is actually a positive signal:

• Increasing dividend coverage ratio means the company has more earnings available to cover dividend payments
• It indicates improving ability to sustain dividends, not a warning sign

Key Concept: The most reliable early warning sign of unsustainable dividends is when they are being paid from sources other than sustainable operating cash flows, particularly when financed by debt.