It’s not hard to find dividend-paying stocks that yield more than a term deposit, often paying twice and sometimes even three times as much as the account interest. Telstra Corporation Ltd (ASX: TLS) is one of the favourites of income investors, with its 5.4% fully franked yield thoroughly smashing term deposits.

Before buying Telstra for its dividend however, you need to ask: ‘Is this kind of payout sustainable?‘ The company’s dividend history – one of the most consistent payouts on the ASX – might appear to speak for itself but investors also need to take a look at the company’s cash flows.

Here’s what you need to know:

Telstra Corporation cash flow statement* 2016 half year ($million) 2015 half year ($million) 2015 full year ($million) 2014 full year ($million)
Receipts from customers 15,642 14,243 29,521 28,950
Payments to suppliers and employees (11,128) (9,780) (19,621) (18,710)
Income taxes paid (989) (927) (1,755) (1,774)
Net cash flow from operations 3,677 3,694 8,311 8,613
Capital expenditure (‘capex) including investments** (2,195) (3,164) (6,206) (4,018)
Proceeds from sale of investments and property 485 221 514 2,888
Net cash used in investing activities (1,759) (3,432) (5,692) (1,130)
Proceeds from borrowings 3,009 594 1793 1,572
Repayment of borrowings (1,789) (1,805) (3,460) (1,478)
Dividends paid to shareholders (1,893) (1,866) (4,703)*** (3,545)
Finance costs (420) (471) (916) (947)
Net cash used in financing activities (1,160) (4,193) (6,882) (4,430)
Net increase/decrease in cash 758 (3,931) (4,263) 3,053
Cash at end of reporting period 2,165 1,669 1,396 5,527

*I’ve excluded or collapsed small line items to save space, which is why the figures above don’t always add up. Cash flow lines in bold are always correct. All figures sourced from company reports.

**~75% of Telstra’s capex is in property, plant, and equipment, ~25% is in intangible assets, and a microscopic fraction is on investments

***includes $1,004 million paid for share buybacks

I’ve included the full-year 2015 and 2014 to give some perspective, as Telstra can have quite disproportionate half-yearly results depending on its activities. As you can see from the table, Telstra generates a monstrous amount of cash, but spends very heavily on dividends and investment. It’s necessary to look back at least a couple of years with Telstra to see how its expenditure and cash on hand can fluctuate – there’s a difference of $4.2 billion dollars between 2014 and 2015. Looking back is also necessary because occasionally the company spends more than it earns in a given half, and uses debt to make up the difference.

Ordinarily a cause for concern, this kind of behaviour is more a function of the activities Telstra undertakes and the timing of borrowing and repayments. Telstra’s debt has been climbing in recent years though and $17 billion in debt might make some investors pause for thought – but the truth is Telstra’s debt is relatively small alongside its $70 billion market cap, and the debt is also underpinned by $20 billion in tangible assets (plus cash and trade receivables), a figure which is probably achievable in the event of an asset sale.

Dividends work out to be approximately 50%-ish of the company’s cash flow from operations, with the rest used for capital expenditure. Ordinarily I would prefer a company keep some of its cash, but because of Telstra’s business and financial situation (see below), it can comfortably spend it all.

Telstra’s debt is relatively inexpensive, with finance costs of $840 million (if we double half-year figures) representing a cost of debt of just under 5% per annum. This is covered 4-5 times over by the company’s net cash from operations. Telstra reports ‘interest cover’ (EBITDA divided by net interest) of 14.4 times, but I like operating cash flows for sustainability testing as it’s easier to role-play ‘so what if…?‘ scenarios. Telstra also reports that its gearing (net debt to net debt plus equity) of 48.7% is slightly below its target range of 50%-70% and interest cover of 7 times. Investors then can expect more debt in the coming years.

Telstra has an average debt maturity of just under 5 years, which could mean higher interest rates are in store further down the track as it refinances – although, there’s no sign of those higher rates anywhere on the horizon. There could also theoretically be problems refinancing/taking on additional debt if the company hits big trouble, but that appears significantly less likely than at some other businesses.

I haven’t discussed Telstra’s business much as I’m assuming most investors are familiar with it – that network of poles, wires, cellular and data services that so many of us rely on every day. As the largest player in the market and in a highly defensive industry, Telstra’s earnings are reliable and it can afford to take on debt, and as we’ve seen above its dividends are also affordable.

I don’t like the idea of a future Telstra with 70% gearing, but based on all the information above and with the caveats I mentioned, I would say that Telstra’s dividends are extremely sustainable, and it can also handle higher debt.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.