When a share price falls by 13% in one day there are nearly always lessons to be learned. Shaft Sinkers (SHFT) suffered this fate on Monday (29 Apr) when the £18.8 million cap unveiled full-year results which featured a 15% drop in sales, 75% plunge in pre-tax income and the cancellation of its final dividend.

At the interim stage (30 Aug) the mine tunnelling expert had held its 2.4p interim distribution, a move which doubtless sparked the interest of those investors seeking income for their portfolio. After all, an unchanged 4.8p final payout would have made for 7.2p in total on a share price of 42.5p, or a 16.9% yield.

When something looks too good to be true it usually is and Shaft Sinkers’ dividend woe is a classic example of this. I am not trying to be smart after the fact. Remember that Government Gilts are generally seen as risk free, as the UK is good for the interest payments and you get your initial investment back once the bonds mature. Ten-year paper as I write offers a yield of just 1.65%. So if you are getting 1.65% a year for purportedly taking no risk at all, then the implication is you are taking an awful lot of chances hunting about for a 16.9% yield from a small cap. In Shaft Sinkers' case the risk taken was ultimately evidenced by how the shares responded to the passing of that final payment.

A simple test such as that one would have signalled danger without doing any detailed financial analysis at all. If even that is too much trouble, and you are looking for income to boost your portfolio pot, then you can always go down the managed funds route and pay for the expertise of trusted money managers such as Invesco Perpetual's Neil Woodford, one of whose funds is described in more detail in this week's Cover Story.

Sniff test

You can also learn how to quickly assess just how safe a firm's dividend payments are via a quick check of the report and accounts and consensus broker estimates.

The first check is to assess dividend cover. This can be calculated as:

forecast earnings per share (EPS)

forecast dividend per share (DPS)

This is expressed as a ratio. Ideally cover should exceed 2.0 to 2.5 times. Anything below 2.0 needs to be watched and a ratio under 1.0 suggests danger - unless the firm is a Real Estate Investment Trust, obliged to pay out 90% of its earnings to maintain its tax status, or it has fabulous free cashflow and a strong balance sheet.

The second test is to assess whether the earnings per share forecast is any good and what could potentially go wrong. Here, you must read the balance sheet and profit and loss account. Note how Shaft Sinkers’ 15% fall in sales prompted a 75% drop in pre-tax income and left the 7.2p distribution uncovered. This is called operational gearing.

The extent to which a firm is operationally geared is the result of how its cost base is broken down between so-called variable and fixed costs. Variable costs tend to be raw materials. They usually move in line with the volume of goods sold or service shipped. Fixed costs include utility bills, rent, the depreciation charge relating to plant and equipment or even staff and research spending, depending on the business.

You will see how cost of goods only fell 9% against the 15% drop in sales, while operating expenses slid 25%, to suggest Shaft Sinkers has relatively fixed costs. A quick check to gauge fixed-asset intensity is the line ‘property plant and equipment’ in the balance sheet. Compare this to total shareholders' equity and sales. Capital-intensive industries that use a lot of kit will have a higher ratio than software or service firms where the assets are people, not manufacturing equipment or factories, as shown below.

It is therefore possible to judge whether a firm's earnings will be volatile or not. You can look at how profits change in relation to sales, while assessing the asset intensity of the balance sheet can help.

This may seem daunting but it will become second nature. You can also still use common sense. The old rule of thumb used to be any dividend more than 1.5 times the ten-year Gilt had to be treated with caution. Central bank buying of bonds rather wrecks that but any dividend yield on a stock north of say 4.5%, almost three times the risk-free rate, should be subject to great scrutiny before you trust it.