After two profit warnings in two months, Tesco has taken an axe to its dividend, as well as reducing its capital investment in stores and growth. As a result, shareholders in Britain's biggest grocer will see their cash dividends slashed by three-quarters.

Tesco has admitted that its 2014 trading profit could be as low as £2.4 billion, more than a quarter below its 2013 figure of £3.3 billion. This would be the third year in a row of falling profits at Tesco, once considered the unstoppable juggernaut of British high streets.

Obviously, times are tough for Tesco, which is why previous chief executive Philip Clarke announced his departure in late July. The retailer is taking a battering at the discount end of the market from Aldi and Lidl, while Waitrose gains ground among upmarket shoppers.

Though sales have risen over the past five years, Tesco's market share has been falling since 2012. Indeed, the latest figures show year-on-year sales falling 4% in the 12 weeks to 17th August. Tesco's latest market share is down to 28.8%, almost two percentage points below the 30.7% recorded in March 2011.

With sales, profits and market share on a downward path since 2012, Tesco has been forced to slash its yearly cash dividend paid to shareholders. Previously Tesco shares offered a juicy dividend yield of 6%. That's more than 50% above the FTSE 100's 3.8% yield. This made Tesco the second-highest-yielding share in the blue-chip index, behind rival Morrisons' 7% yield.

However, it will now pay just 1.16% per share.

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Dividends in distress

Financial history shows us that when a company's shares offer a very high dividend yield, this can be an indicator of one of two things. First, that the business is booming and is generating impressive cash flow and profits to fund bumper payouts. Second, that the firm's dividend is unsustainable and in danger of being cut in future.

In fact, bumper dividends frequently indicate troubled companies, because dividend yields rise as share prices fall (all else being equal). So when a firm's share price is in free-fall, its dividend yield can go through the roof.

For example, take RSA (formerly Royal & SunAlliance). The global insurance group issued three profit warnings at the end of last year, after discovering serious irregularities in its Irish operations. As losses of hundreds of millions of pounds mounted up and RSA's share price plunged, its dividend yield soared well above 8%. This was a clear indicator of corporate distress, as shown when the insurer finally took a knife to its shareholder payout.

Today, RSA's dividend yield stands at a much more modest 2.3%.

A powerful example of 'dividend distress' was shown by the big banks' dividend yields during the global financial crisis of 2007/09. As the financial system teetered on the brink and bank share prices plunged, their dividend yields leapt into double digits. Predictably, these payouts were cut or cancelled. Lloyds Banking Group hasn't paid a dividend since October 2008 and Royal Bank of Scotland since September 2008.

Dividends in doubt

The wonderful thing about dividends is that, once paid, these regular cash payouts to shareholders cannot be taken back. 

However it is vital for investors to understand that no dividend is guaranteed or written in stone. Taking account of business needs, a company's directors can raise, lower or even cancel future dividends as they see fit. Only when a dividend is declared and paid can it be viewed as completely certain.

Of course, to pay out dividends, companies need to have ready cash at hand to meet these quarterly or half-yearly payments. Indeed, for Britain's biggest businesses, these cash outlays amount to billions of pounds a year - payouts which are funded by their huge profits.

The really big worry is when a dividend is barely covered by a company's earnings or, even worse, the dividend is uncovered. In the latter scenario, a company's profits are insufficient to meet its yearly dividend, so the firm is forced to use cash reserves to maintain its cash payouts. Such a state of affairs cannot continue forever, indicating a potential dividend cut is on the cards.

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Spotting dodgy dividends

What warning signs should you look for when scouting for decent dividends? Here are three red lights for investors to watch out for:

1. Stable and rising dividends are coupled to financial success. If a business is thriving, so too will its dividend over time. So the first warning sign of dodgy dividends is company weakness, such as declining sales, margins, profits, cash flow or cash reserves. If a business is generating lower levels of cash, then its dividend could be in the firing line.
2. When dividend-hunting, always check that earnings per share (EPS) are greater than the yearly dividend per share (DPS). If EPS is lower than DPS, then a dividend is not fully covered and, therefore, surely in jeopardy at some point.
3. For solid dividends, search for shares whose dividends are easily covered by earnings. Personally, I prefer an EPS:DPS ratio above two (when dividends are covered more than twice by earnings). At a pinch, dividend cover above 1.5 may be enough for some dividend-hunters.

The biggest dividends

Here is a list of the highest-yielding shares in the FTSE 100 index. All seven of these shares offer dividend yields above 5%, which is more than double the yearly interest you could earn from cash deposits:

Source: www.topyields.nl, 29th August 2014

Looking at this list, we see two major rivals of Tesco: Sainsbury's and Morrisons. With Tesco set to launch another salvo in another industry-wide price war, these two grocers could see their sales come under pressure. In time, their dividends could follow suit, so please don't rely on Morrisons' 7% yield or Sainsbury's 5.7% payout. Indeed, Sainsbury's halved its dividend in 2005 to fund previous price cuts.

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