Many publicly traded companies distribute a portion of their earnings to investors in the form of dividends paid to stockholders. Each stockholder receives a certain amount of money for each share of company stock that he owns. How a company calculates the amount of its dividend will depend on various factors such as revenues and profits, assets and projected cash flow. The ratio of the dividend to the company's total income, known as the payout ratio, may be affected by interest rates, but this is not always the case.
The payout ratio is the ratio of a company's income for a particular quarter, calculated as earnings per share, to the size of the dividend that the company elects to pay. If a company earns $10 per share and pays out a dividend of $1 per share, then its payout ratio would be 10 percent. The dividend ratio can be affected by many factors, including interest rates.
When a company chooses to borrow money, interest typically is charged on the principal. The amount of interest charged by a lender depends on a number of factors, including the company's credit rating. Interest rates can also be affected on a macro scale, particularly by changes in an economy and the policies adopted by a country's central bank.
Rise in Rates
A rise in interest rates means that, all things considered, the amount of interest that a company pays to borrow money increases. The most profound effect of this shift is that borrowing will slow because it is more expensive. In some cases, this will cause companies to plan for slower expansion which, in turn, may trigger a slowing of the economy, leading to lower revenues.
Effect of Payout Ratio
If a company experiences lower revenues due to a hike in the interest rate, the business may decide to lower its payout ratio. Money that would normally be distributed as dividends might be needed to meet operating expenses. Likewise, the company may elect to keep more cash on hand because borrowing has become more expensive. These factors, led by higher interest rates, would decrease the payout ratio.
- "Economics"; Roger A. Arnold; 2009
- Medioimages/Photodisc/Photodisc/Getty Images