Make the Payout Ratio Work for Your Credit Union in Challenging Times

The term payout ratio was originally applied in the stock market as a measure of return to investors (dividend payout ratio). To calculate this ratio, the dollar amount of dividends paid to stockholders is divided by earnings for profits. The results are used by investors to determine the dividend strategy and expectations of the company. Along those lines, credit unions can benefit from the concept of payout ratios to measure the percent of interest income that is paid to members in the form of interest on deposits.

The concept is analogous to the debt-to-income ratio used in underwriting a loan application. As all lenders know, the debt-to-income ratio is a method of determining what size of monthly payment the borrower can afford to pay. In order to calculate the debt-to-income ratio, the borrower’s income and total payments for loans are totaled. The ratio is calculated by dividing total debt payments by total income. Credit unions put in policy the guidelines for maximum debt-to-income ratio that will be accepted for loans.

For the payout ratio concept to work, a similar equation and calculation is made. Dividends paid on deposits make up the debt portion of this equation. Total interest income received from both loans and investments is the income portion. By dividing interest expense by interest income we determine what percentage of interest income is being paid to members on their deposits.

Using a stochastic model we can then determine the optimum payout ratio range for any credit union. The optimum current location in the range changes as the loan-to-share ratio changes. As the loan-to-share ratio increases, the location within the payout ratio range increases as well (up to the maximum of the range).

A higher payout ratio for a credit union indicates that management is keeping the cost of funds high and may not be keeping adequate earnings to build equity and reinvest in the credit union. Alternatively, applying this concept effectively can take the gamble out of pricing by leveraging statistically proven methods for assuring each of your products provides a fair return.

Dr. Randy Thompson, PhD is president and CEO of Thompson Consulting & Training, Inc. For more information on Thompson Consulting & Training, Inc visit: www.tctconsult.com

You can hear more from Randy Thompson at the 2010 Convention and Annual Business Meeting, breakout session on September 16, “ALM and Strategically Pricing Your Products.” To register or for more information visit: www.waleague.org/convention

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