£5,000 in savings could potentially be turned into a £2,200 annual second income. Here’s how!

With £5,000 tucked away, it’s perfectly sensible to think about turning it into a second income. There are a few paths: side gigs, rental income, peer-to-peer lending. Personally, I prefer investing in dividend-paying companies – and here’s why.

Let’s run some simple maths. Suppose a diligent investor builds a portfolio of dividend stocks with an 8% average yield. Over 10 years, by reinvesting the dividends, that £5,000 could grow to over £12,500. By then, it would pay roughly £1,000 a year in dividends, if the yield held.

Extend that to 20 years, and it could balloon to over £27,600, yielding about £2,200 in annual payments. And doubling the investment would roughly double the dividend stream.

But hitting those yields isn’t easy. Many income portfolios today deliver between 6% and 7%. Trying for 8% regularly means veering into riskier territory — companies whose yields aren’t all sustainable. 

However, it’s not impossible. Here’s how I’d screen the situation.

Picking dividends

I like to focus on metrics such as dividend cash ratio (DCR), continuous dividend history and payout ratio. A company that’s paid dividends for over 10 years with a payout ratio under 100% and a DCR of 2, suggests it has enough profit and cash to cover future distributions.

In a thought experiment, I screen FTSE stocks and find 10 that fit the script:

Their yields average about 7.75%. Pretty close to 8% with strict constraints. Loosen one or two filters and higher-yielding names could pop up. But a closer analysis of each stock’s critical.

Digging deeper

If a company’s in debt, that’s a risk to dividends. So the first thing to check is the balance sheet. Using ZIGUP as an example, its debt-to-equity is about 0.82, with a quick ratio of 0.95. Since they’re both below 1, that’s adequately covered.

In its latest results, it generated net income of £79.84m from £1.81bn of revenue – a net margin of 4.4 %. That’s modest, but sustainable for now.

It holds £458.59m in cash and equivalents, but free cash flow’s negative – a red flag. Still, since dividend coverage is sufficient, I’d say it’s still a stock worth considering for an income portfolio.

That said, negative free cash flow is a serious risk. If that persists, the company might struggle to maintain dividends. So far, payouts look ok but it’s something I’d keep a close eye on.

Other risks include cyclicality in the mobility sector and dependence on fleet spending and vehicle demand. If costs rise or demand weakens, revenues and margins may slip. With tight cash flow, a surprise revenue drop could force a dividend cut.

Final thoughts 

An average yield target of 8% is aggressive. So any income-seeking strategy built around it should be only part of a larger diversified portfolio. But the example shows what’s theoretically possible, and the steps to vet dividend names more safely.

It’s wise to follow trends in familiar sectors, stick to companies you understand and maintain diversification across industries and regions.

These screening steps are just a starting point. For keen investors, the London Stock Exchange holds many more promising opportunities for those ready to put in the work.

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Mark Hartley has no position in any of the shares mentioned. The Motley Fool UK has recommended B&M European Value and Pets At Home Group Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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