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What is Payout Ratio and Retention Ratio?


Payout ratio: 
The amount paying as dividend to shareholders out of net income is known as payout ratio. The higher ratio shows that more net income is used to pay dividend instead of reinvesting in a business. The lesser ratio shows that company have more retained earnings in comparison to dividend paid to shareholders. Payout ratio is shown in a percentage. Retained earnings means instead of paying dividend to shareholders out of net income, the amount reinvested in a business for future expansion or business operation.

Formula:
Payout ratio = Dividend per share (DPS) / Earnings per share (EPS)
Or
Dividend paid in a year / Net income
DPS (Dividend per Share) = Total dividend / Number of shares
EPS (Earnings per Share) = Earnings after tax & preferred dividend / Number of outstanding shares

Retention ratio: It is just opposite of payout ratio. The amount of net income reinvested in a company or retained in a company instead of paying as dividend is known as retention ratio. Higher the ratio more will be the amount reinvested in a company for future expansion and the lesser the ratio shows more amount is paid as dividend to shareholders.

Formula:
Retention ratio = Retained earnings / net income
Or
Retention ratio = 1 – Payout ratio
Or
Retention ratio = 1 – (Dividend / Net income)
Or
Retention ratio = (Net income – Dividend) / Net income

Example: Mr. Naveen wants to invest in those investments which provide high value in future. With the help of payout ratio find out the best investment for Mr. X. Further information is given below:
·         Company P’s retention ratio is 45%.
·         Company Q’s retention ratio is 80%.
·         The current net income of Company R is Rs.70, 000 and the total dividend in a year is 10,000.

Solution:
Payout ratio of Company P:
Payout ratio = 1-retention ratio
= 1- 45%
= 55%.
Payout ratio of Company Q:
= 1 – 80%
= 20%.
Payout ratio of Company R:
Payout ratio = Dividend in a year / Net income
= 10, 000 / 70, 000
= 14.28%
Company R stocks is best for Mr. X because it currently not provide high dividend but it reinvest the amount of net income for future expansion of a company which gives capital gain in future.

Example: Company A has declared dividend of Rs.2 per share. And the company issued 5, 000 common shares and 1, 000 6% preference share. Find out the payout ratio if net income of a company is Rs.85, 0000.

Solution: Payout ratio = Dividend per Share (DPS) / Earnings per Share (EPS)
EPS = net income after preference share dividend/ Number of shares
= 79, 900 / 5, 000
= 15.98
Payout ratio = 2 / 15.98
= 12.51%

Example: Company X has declared Rs. 5,000 dividend. The company has not issued any preference share. The net income of a company is Rs. 62, 000 and outstanding shares are 1, 200. Find out the retention ratio.

Solution: Retention ratio =1 - Dividend in a year / Net income
=1 – (5, 000 / 62, 000)
= 92%

Example: Company X and Y are two companies which issue 1, 000 and 1, 200 stocks respectively. The total dividend was declared by both the companies are Rs. 5, 000 and Rs. 4, 500 respectively. The Earnings per share of Company X is Rs. 6 per share and Company Y is Rs. 4 per share. Find out which investment is best for the investor if he wants regular income from his investment.

Solution: If an investor wants regular income from his investment then the payout ratio is best method to know how much dividend paid by company in a year.
Payout ratio = Dividend per Share (DPS) / Earnings per Share (EPS)
DPS (Dividend per Share) = Total dividend / Number of shares
Company X:
DPS = 5, 000 / 1, 000
= Rs. 5 per share   
Payout ratio = 5 / 6
= 83%      
Company Y:
DPS = 4, 500 / 1, 200
= Rs. 3.75 per share
Payout ratio = 3.75 / 4
= 93.75%
Company Y’s stock is best option for investors.                      




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