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Financial Characteristics of Utilities
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Most utilities carry a great deal of leverage, both operationally and financially. On the operations side, most of the costs are fixed, with fuel being the only significant variable cost. This operational leverage is not very important because, beyond normal seasonal patterns, demand for power does not change much one way or the other over time.

The financial component of their leverage is much more important today. It Is easy to understand why utilities formerly welcomed taking on massive debt. With regulators capping rates, companies found that their profit margins and the allowed return on assets were kept positive but comparatively low. An easy way to increase the return on equity (as well as earnings and dividends per share) was to crank up the financial leverage.

From the lender's perspective, the utilities operated stable businesses with largely predictable cash flows, making servicing the interest easy. They were also eager to lend because the loans were backed by hard assets such as power plants and real estate that made for excellent collateral.

Unfortunately, many utilities are today struggling with their legacy of high debt. Though debt was not so important when the sector was more regulated

Many investors are drawn to the utilities sector because of the generous dividend yields many of the stocks in the sector pay. However, dividends are only as safe as the financial health of the companies that pay them. With the utilities sector as a whole paying out roughly three-quarters of its earnings as dividends, the high payout ratio does raise the risk of dividends being cut when times are tough. Watch out if the pay­out ratio creeps above 90 percent or so or if the debt-to-total-capital ratio rises above 50 percent.

The saying "If it seems too good to be true, it probably is" applies to high dividend yields. If a stock's yield seems ridiculously high — for example, 15 percent when com­parable investments are yielding only 5 percent — it's probably a sign the company has run into some sort of trouble. After all, when companies run into trouble, their stocks tend to fall, which pushes up their yields. In addition, an easy way for a struggling firm to conserve cash is by cutting dividend payments.

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