What Is Pro Rata?
Pro rata is a Latin term used to describe a proportionate allocation. It essentially translates to "in proportion," which means a process where whatever is being allocated will be distributed in equal portions.
If something is given out to people on a pro rata basis, it means assigning an amount to one person according to their share of the whole. While a pro rata calculation can be used to determine the appropriate portions of any given whole, it is often used in business finance.
- If something is given out pro rata, it typically means everyone gets their fair share.
- Pro rata means proportionally, such as fees that rise pro rata with employee salaries.
- The practice of prorating can apply in many areas, from billing for services to paying out dividends or allocating business partnership income.
Understanding Pro Rata
Pro rata typically means that each party or person receives their fair share in proportion to the whole. Pro rata calculations can be used in many areas, including determining dividend payments, which are cash payments by corporations paid to shareholders. Pro rata is also used to determine the amount of premium due for an insurance policy that only covered a partial term. Allocating the appropriate portion of an annual interest rate to a shorter time frame can also be done via pro rata.
Pro Rata and Dividends per Shareholder
When a company pays dividends to its shareholders, each investor is paid according to their holdings. If a company has 100 shares outstanding, for example, and issues a dividend of $2 per share, the total amount of dividends paid will be $200. No matter how many shareholders there are, the total dividend payments cannot exceed this limit. In this case, $200 is the whole, and the pro rata calculation must be used to determine the appropriate portion of that whole due to each shareholder.
Assume there are only four shareholders who hold 50, 25, 15, and 10 shares, respectively. The amount due to each shareholder is their pro rata share. This is calculated by dividing the ownership of each person by the total number of shares and then multiplying the resulting fraction by the total amount of the dividend payment.
The majority shareholder's portion, therefore, is (50/100) x $200 = $100. This makes sense because the shareholder owns half of the shares and receives half of the total dividends. The remaining shareholders get $50, $30, and $20, respectively.
Pro Rata for Insurance Premiums
Another common use is to determine the amount due for a partial insurance policy term. Most insurance policies are based on a full 12-month year, so if a policy is needed for a shorter term, the insurance company must prorate the annual premium to determine what is owed. To do this, divide the total premium by the number of days in a standard term, and multiply by the number of days covered by the truncated policy.
For example, assume an auto policy that typically covers a full year carries a premium of $1,000. If the insured only requires the policy for 270 days, then the company must reduce the premium accordingly. The pro rata premium due for this period is ($1,000/365) x 270 = $739.73.
Pro Rata for Interest Rates
Pro rata calculations are also used to determine the amount of interest that will be earned on an investment. If an investment earns an annual interest rate, then the pro rata amount earned for a shorter period is calculated by dividing the total amount of interest by the number of months in a year and multiplying by the number of months in the truncated period. The amount of interest earned in two months on an investment that yields 10% interest each year is (10% / 12) x 2 = 1.67%.
When it comes to bonds, payment on accrued interest is calculated on a pro rata basis. Accrued interest is the total interest that has accumulated on a bond since its last coupon payment. When the bondholder sells the bond before the next coupon date, they're still entitled to the interest that accrues up until the time the bond is sold. The bond buyer, not the issuer, is responsible for paying the bond seller the accrued interest, which is added to the market price.
The formula for accrued interest is as follows:
AI=Face Value of Bond×Coupon Rate×Time Factorwhere:AI=Accrued InterestCoupon Rate=Number of Periods Per YearAnnual Coupon RateTime Factor=Days in Payment PeriodDays Lapsed Since Last Payment
The factor is calculated by dividing the length of time the bond was held after the last coupon payment by the time from one coupon payment to the next.
For example, consider a bondholder who sells their corporate bond on June 30th. The bond has a face value of $1,000 and a 5% coupon rate, which pays semi-annually on March 1st and September 1st. The buyer of the bond will pay the seller: