Ratios: Payout Ratio - Online Tutor, Practice Problems & Exam Prep

The dividend payout ratio measures the percentage of earnings distributed to shareholders as dividends. It is calculated by dividing cash dividends by net income, yielding a ratio that indicates how much is paid out per dollar of net income. A ratio above 100% is uncommon, as it suggests financial issues. Companies often maintain a consistent payout ratio, which can signal stability or potential reinvestment strategies. A sudden decrease in dividends may indicate financial difficulties, prompting further investigation by investors.

Ratios: Payout Ratio

All right. Let's discuss a ratio here, the dividend payout ratio. So the dividend payout ratio is just sometimes called the payout ratio. And guess what? It's going to measure the percentage of earnings that are paid out, distributed to the stockholders as dividends. So this doesn't really fit into the categories that much, but I guess it fits into a profitability ratio because we're dealing with net income here, okay? Notice our dividend payout ratio, we're going to take the cash dividends that are paid to our shareholders and we're going to divide it by net income. So it's going to give us a ratio of how many dollars of dividends for each dollar of net income. You wouldn't expect there to be dividends higher than net income, that generally doesn't happen. You wouldn't have a ratio above 100%. And we usually show this as a percentage, so you'll want to multiply by a 100 to get to percentage mode. But what happens is most companies are going to aim to have a dividend payout that they maintain year to year. So they might say, oh, we're going to pay out 5% of our earnings as dividends every year. So whatever the earnings end up being, 5% of it, that's the dividend you can expect. Okay? So that depends on the company and some companies don't pay dividends at all, right? That's not necessarily a bad thing either. That could just mean that they're focused on reinvesting into the company. So what does a low dividend ratio mean? Well, like I said, it's not necessarily a bad thing. This indicates that they're reinvesting in the company. That's funny. I just said that. And then the other thing is that a decrease in the payouts, well, this could indicate something. Right? If they've had consistent dividend payouts every year, every quarter for a long time, and all of a sudden they're cutting that down. They're like, oh we're going to pay less dividends. You might want to look into that. That could be a red flag of some financial problems, right? Because they're no longer as comfortable paying out those earnings as dividends, maybe they need that money for something else. Maybe they're just trying to reinvest and grow in the business. Whatever it is, you're going to want to look into it. If it's been consistent year to year, and now all of a sudden it's dropping. As an investor, you're going to want to check that out. Cool? Alright. So it's not such a crazy ratio. Let's go ahead and do some practice problems and calculate our dividend payout ratio.

ConsistoCo has a policy to maintain a constant payout ratio from year to year. During the previous fiscal year, net income totaled $1,200,000 and ConsistoCo paid $240,000 in dividends. This year, due to the settlement of a lawsuit, the company had net income of $700,000. What amount of dividends would investors expect ConsistoCo to declare this year?

• A. $70,000
• B. $140,000
• C. $190,000
• D. $240,000

Dive Company maintains a policy to have a consistent payout ratio from year to year. Selected financial information for the company is as follows:

What amount of dividends would the company pay during the current year? 

• A. $20,000
• B. $8,000
• C. $18,750
• D. $15,000

Here’s what students ask on this topic:

What is the dividend payout ratio and how is it calculated?

The dividend payout ratio measures the percentage of a company's earnings distributed to shareholders as dividends. It is calculated using the formula:

$\frac{\mathrm{Cash\; Dividends}}{\mathrm{Net\; Income}}\times \; 100$

This ratio indicates how much of the net income is paid out as dividends. For example, a 30% payout ratio means that 30% of the net income is distributed as dividends, while the remaining 70% is retained by the company for reinvestment or other purposes.

Why might a company have a low dividend payout ratio?

A low dividend payout ratio is not necessarily a bad thing. It often indicates that the company is reinvesting a significant portion of its earnings back into the business to fuel growth, research and development, or other strategic initiatives. This can be a positive sign for long-term investors who are looking for capital appreciation rather than immediate income. Additionally, some companies may choose to retain earnings to build a financial cushion for future uncertainties or opportunities.

What does a sudden decrease in the dividend payout ratio indicate?

A sudden decrease in the dividend payout ratio can be a red flag for investors. It may indicate that the company is experiencing financial difficulties and needs to conserve cash. Alternatively, it could mean that the company is shifting its strategy to reinvest more earnings into growth opportunities. Investors should investigate the reasons behind the change, looking at the company's financial statements, management discussions, and market conditions to understand the underlying causes.

Can a company have a dividend payout ratio above 100%?

It is uncommon for a company to have a dividend payout ratio above 100%, as this would mean the company is paying out more in dividends than it earns in net income. Such a situation is usually unsustainable and may indicate financial distress. Companies with a payout ratio above 100% might be using retained earnings or taking on debt to maintain dividend payments, which could be a warning sign for investors about the company's financial health.

How does the dividend payout ratio affect investor perception?

The dividend payout ratio can significantly affect investor perception. A stable or increasing payout ratio is often seen as a sign of financial health and reliability, attracting income-focused investors. Conversely, a decreasing payout ratio might raise concerns about the company's financial stability or future profitability. Investors use this ratio to gauge the sustainability of dividend payments and the company's overall financial strategy.