Which of the following companies has the LOWEST payout ratio?
a company with $49 million cash dividends declared on common stock and a net income of $203 million
a company with $28 million cash dividends declared on common stock and a net income of $142 million
a company with $18 million cash dividends declared on common stock and a net income of $94 million
a company with $97 million cash dividends declared on common stock and a net income of $376 million
The Correct Answer and Explanation is:
To determine which company has the lowest payout ratio, we must first understand what the payout ratio means.
Definition: Payout Ratio
The payout ratio is a financial metric that shows the percentage of net income a company pays to shareholders in the form of dividends. It’s calculated using the formula: Payout Ratio=(Dividends DeclaredNet Income)×100\text{Payout Ratio} = \left(\frac{\text{Dividends Declared}}{\text{Net Income}}\right) \times 100
Step-by-Step Calculations
Let’s calculate the payout ratio for each company:
1. First Company:
- Dividends = $49 million
- Net Income = $203 million
Payout Ratio=(49203)×100≈24.14%\text{Payout Ratio} = \left(\frac{49}{203}\right) \times 100 \approx 24.14\%
2. Second Company:
- Dividends = $28 million
- Net Income = $142 million
Payout Ratio=(28142)×100≈19.72%\text{Payout Ratio} = \left(\frac{28}{142}\right) \times 100 \approx 19.72\%
3. Third Company:
- Dividends = $18 million
- Net Income = $94 million
Payout Ratio=(1894)×100≈19.15%\text{Payout Ratio} = \left(\frac{18}{94}\right) \times 100 \approx 19.15\%
4. Fourth Company:
- Dividends = $97 million
- Net Income = $376 million
Payout Ratio=(97376)×100≈25.80%\text{Payout Ratio} = \left(\frac{97}{376}\right) \times 100 \approx 25.80\%
Conclusion
Now let’s compare:
- 1st Company: 24.14%
- 2nd Company: 19.72%
- 3rd Company: 19.15% ← Lowest
- 4th Company: 25.80%
✅ Correct Answer:
A company with $18 million cash dividends declared on common stock and a net income of $94 million
Explanation Summary (300 Words)
The payout ratio is a vital indicator of how a company balances rewarding shareholders with reinvesting in its business. A lower payout ratio suggests the company is retaining a larger portion of its earnings, which could be used for growth, debt reduction, or reserves. This is often seen in growing companies or those reinvesting heavily in future operations.
In this question, we are asked to identify the company with the lowest payout ratio among four options. Using the standard formula for payout ratio — dividends divided by net income — we computed the values for each company. The third company, which paid $18 million in dividends from a $94 million net income, had the lowest ratio of approximately 19.15%.
This implies that only 19.15% of its earnings were distributed as dividends, while the remaining 80.85% were retained within the company. This financial strategy might reflect a conservative dividend policy, potentially signaling future growth, internal investment opportunities, or cautious management.
In contrast, higher payout ratios (such as 25.80% in the fourth company) indicate more generous dividend policies but might also mean fewer funds for reinvestment. While higher dividends are attractive to income-focused investors, low payout ratios often appeal to those prioritizing capital appreciation.
Therefore, identifying and understanding the payout ratio helps investors evaluate a company’s dividend policy in context with its overall financial strategy.