What is Pro Rata?
Pro rata refers to the proportional distribution of a sum across a number of units.
How Does Pro Rata Work?
A Latin term meaning "in proportion," pro rata is a method of allocating fractional amounts of something equally among all parts of a whole. Where interest rates are concerned, the practice of pro rata allows a periodic interest rate to be divided into smaller units (e.g. converting an annual rate into a monthly rate). This action is called "prorating" and may be used in reference to a bond being sold at discount; to a total dividend as divided among entitled shares of stock outstanding; or to an annual insurance premium adjusted for the remaining number of months in the year following the purchase of a policy.
To illustrate, suppose company XYZ declares a $1 million cash dividend. There are currently one million entitled shares outstanding in the market. Company XYZ, therefore, prorates the dividend to $1 per share based on the following math:
$1,000,000 dividend / 1,000,000 shares outstanding = $1 dividend per share outstanding
Why Does Pro Rata Matter?
The pro rata system provides a method for allocating single-unit amounts among several smaller units. This becomes particularly important for the sale and purchase of time-sensitive items such as interest-bearing securities and annual contracts or periodical subscriptions.