Ever thought about buying shares that pay dividends, then sitting back and watching the passive income roll in?

Lots of people have exactly that thought – and make it happen. Not only is it possible, it can be simple and – unlike some supposedly passive income plans – genuinely passive.

But there are some key things to understand if seriously considering such an approach.

Dividend yield

One is dividend yield.

This has some similarities with the interest rate on a bank or building society account. A yield of 5% means dividends in one year that equate to 5% of the purchase cost of those shares.

But there are some big differences compared to an interest rate.

Dividends are never guaranteed and can be cut, cancelled, or increased without prior notice. That said, some companies do signal they are considering reviewing their capital allocation policy, which can be a coded warning that a cut might be in the works.

That is why you sometimes see people talk about ‘forward yield’ (merely an estimate of what the company might pay in the coming year, expressed as a percentage of its current share price) versus plain old yield or ‘historic yield’ (a snapshot of what actually happened – but might not happen in future, remember).

Take my holding in Pets at Home (LSE: PETS). I like the company’s large customer base, extensive branch network, and growing vet group business.

I also like its dividend yield. It is 7.2% — or is it?

Well, yes it is, based on the past year’s payout. But an announced review of, you guessed it, capital allocation priorities means the forward yield is likely lower. Exactly how much, for now, is anyone’s guess.

Cash flows

But why might Pets at Home, or any other company, cut its dividend?

After all, the share’s passive income potential is part of its appeal to shareholders. The board surely knows that a cut could put off some investors, potentially weakening demand for the share.

Knowing that dividends are not guaranteed for any share is important – but it is also important to understand why.

Basically, if a company has enough spare cash, it can decide what to do with it. Dividends are only one potential use of spare cash.

Pets at Home could use some of its spare cash to lower shelf prices, potentially making its retail offer more competitive. After all, that has been one of the firm’s challenges in the past year or two. Getting a handle on a company’s spending priorities can be instructive.

But it is also critical to understand how much spare cash a firm is likely to generate in the first place, before thinking about what it might be used for.

This is where getting to grips with free cash flows matter.

In the first half of its current financial year, for example, Pets at Home’s operating activities generated £107m in net cash flows.

Dividends cost it £38m, which suggests the dividend is well covered. But the company has other costs, such as funding share buybacks.

Understanding how cash flows work is not some boring fixation for accountants. It is vital for any investor serious about trying to build passive income streams from dividend shares!

Should you invest £5,000 in Pets At Home Group Plc right now?

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Christopher Ruane owns shares in Pets at Home.