Before you buy a dividend-paying stock, you'll want to understand a vital concept that a lot of investors miss: Dividend coverage.

Most investors look only at yield. Dividend yield -- the amount of the annual dividend divided by the price paid for the stock -- is an important tenet for all income investors to master. Yield tells you how rich the payout is. Coverage, on the other hand, tells you how safe the dividend is.

How To Calculate Divident Coverage

Calculating a company's dividend coverage takes a little work and a basic familiarity with an income statement. This financial document, typically issued quarterly with the company's earnings report, details exactly what the company took in and what it spent.

If you're not comfortable with these types of documents, it's probably because you haven't seen one or are afraid you won't be able to understand what you see. But there's nothing to be afraid of. An income statement is no harder than reading your monthly bank statement. Now, most of us don't exactly relish that, but you have to admit that it's not very hard. You see what you took in -- your deposits -- and what you spent writing checks or swiping your debit card. An income statement is no more complicated than that!

Income statements are readily available at major financial Web sites like Yahoo and Google. If you have access to professional research through your brokerage, you can usually find the information there, too.

Now, there's a lot of information to look at, but dividend coverage requires only two numbers. They are net income -- the bottom line -- and dividends paid.

Net income is found near the bottom of the income statement. In the fourth quarter of 2008, company XYZ’s profit was $266 million.

What Are Dividends Paid

'Dividends paid' is sometimes listed as a total figure but also is occasionally shown on a per-share basis. If the figure you see is a per-share number, then you will need to research how many shares are outstanding. That's available in the main quote screen on Google Finance and under 'Key Statistics' on Yahoo Finance.

We'll use company XYZ as an example, which had 6.74 billion shares and its quarterly dividend was 32 cents a share. We multiply the dividend by the number of shares, which is $2.07 billion.

See the problem? XYZ paid out more in dividends than it took in as profits. The coverage -- calculated by dividing the dividend by income -- was actually greater than 100%. In fact, it was 778% . That number, of course, is nonsensical -- it means to pay the dividend, XYZ had to dip into its savings account. And by 'its savings account,' I mean 'your money.' It took the dividend from the cash on its books. A move like this simply gives you money you already owned.

Not surprisingly, XYZ cuts its dividend in half soon thereafter. At the current payout, the dividend could bleed the company dry unless earnings improved dramatically. And even if it did, 'saving' money on future dividends allows it to rebuild its cash hoard.

Now, for a more pleasant example, let's look at company ABC. During the same reporting period as the XYZ example, ABC paid a 38-cent dividend to 2.32 billion shares, or roughly $881 million. But it had net income of $995 million.

$881 million divided by $995 million is 0.885, or 88.5%.

The higher the dividend coverage, the shakier the dividend is. One thing analysts will do is to ask themselves what would happen if a company's income fell -- either because of increased costs or decreased revenue, or both, and determine how that would affect the dividend. In ABC's case, it has a little breathing room. It can handle the dividend if net earnings fall.

The best news: Companies with relatively low payout ratios have the ability to increase the dividend. Companies whose dividend obligation is already nearly equal to their net earnings don't have this option, unless they want to raid their cash on hand.

Dividends are a great thing. In fact, over the long haul they are responsible for building most of the wealth created by the stock market. Ben Graham, mentor to Warren Buffett, said paying dividends was the primary purpose of any corporation. If you master the dividend payout ratio and determine a company's dividend coverage, you'll have a better picture of the company's financial footing and be more able to judge whether the payout is sustainable, likely to increase or ripe for a cut.