The equity multiplier formula shows the relationship between the total shareholders’ equity and the total assets of a company. The equity multiplier measures the portion of a company’s assets that are financed by shareholders’ equity which in turn helps one to determine the financial leverage of a company. We will see how to apply this formula in the equity multiplier examples, its importance, and its interpretation.
What is equity multiplier ratio?
The equity multiplier is a financial leverage ratio or a risk indicator that measures the percentage of a company’s assets that are financed by shareholders’ equity rather than debt. It is calculated by dividing the total assets of a company by its total shareholders’ equity.
In general terms, a high equity multiplier is an indication that a company is using a high amount of debt to finance its assets. On the other hand, a low equity multiplier indicates that the company is less dependent on debt. This directly translates to the fact that with less debt, such companies have a sound asset and equity base, and may be better to invest in. We can consider the equity multiplier to be just an indicator of how sound a company’s financial base is.
However, a company’s equity ratio can be regarded as high or low only in comparison to historical standards, the averages of the industry, or the company’s peers.
As investment in assets is key to running a successful business, companies finance the acquisition of their assets either by issuing equity or through debt financing, or a combination of both. Companies that carry a higher debt burden will have higher debt servicing costs which means that they must generate more cash flow in order to sustain a healthy business.
The equity multiplier ratio is an important financial metric that investors take a close look at, as it is also employed in the DuPont analysis for measuring the performance of a company based on certain key performance indicators.
Related: Solvency Ratio Formula and Example
Equity multiplier formula
The formula for calculating the equity multiplier is total assets divided by total shareholders’ equity. That is;
Equity multiplier = Total company assets / Total shareholders’ equity.
There are two components that need to be discussed in the equity multiplier formula, these are the total assets and the shareholders’ equity.
The total assets comprise all fixed assets such as land, building, machinery, plants, furniture, etc, and current assets such as debtors, inventories, prepaid expenses, etc. The shareholders’ equity only includes the funds of common shareholders. It is important to note that preference shares do not form part of this because of the nature of the fixed obligation. The shareholders include both preferred shares and common shares. Both components can be found in a company’s balance sheet.
The equity ratio multiplier alone cannot be used to analyze a company as some industries are capital-centric and are in need of more capital than other industries. An investor needs to pull out other peer companies in a similar industry and calculate their equity multiplier for them to compare it. If one sees that the result is similar to or close to the benchmark of the industry, to the company he intends to invest in, it should be understood that low or high financial leverage ratios are the industry’s benchmark
Equity multiplier examples
The following information has been extracted from the balance sheet of A&B Wears:
|Total shareholders’ equity
Find out the equity multiplier of the firm.
Now, the total assets include both current and non-current assets. That is;
Total assets = $37,000 + $143,000 = $180,000
The total shareholders’ equity has already been given as $540,000
Using the equity multiplier formula:
Equity multiplier = Total company assets / Shareholders’ equity
Equity multiplier = $180,000 / $540,000
Equity multiplier = 0.3333 = 33.33%
One can determine whether this ratio is higher or lower depending on the standard of the industry. It is necessary for every investor to take a look at other companies in similar industries and look at different financial ratios.
Edwin company is an internet solutions company that supplies and installs internet cables in business premises and households. The owner wants the company to go public next year in order to sell shares to the public. Before going public, the company wants to know whether its current equity multiplier is healthy enough to attract creditors. The reports of the previous year indicate that the company owns total assets of $1,000,000 and the shareholders’ equity stands at $800,000
Using the equity multiplier formula:
Equity multiplier = Total company assets / Total shareholders’ equity
Equity multiplier = $1,000,000 / $800,000
Equity multiplier = 1.25
We can say that Edwin Company reports a low equity multiplier which indicates that it is less leveraged since a large portion of its assets are financed by equity while only a small portion is financed by debt. This company only used 20% debt to finance its assets, that is 1,000,000 – 800,000 / 1,000,000 x 100. Therefore, the financing structure of the company is conservative and with this, creditors will be willing to advance debt to it.
Equity multiplier interpretation and analysis
There is no ideal equity multiplier as it varies across sectors or industries. Generally, investors look for companies that have a low equity multiplier. This is because it indicates that the company is using more equity and less debt to finance or purchase its assets. Companies that have a higher debt burden can be financially risky. This is true particularly if the company begins to experience difficulties in generating cash flow from operating activities that are needed to pay back the debt and the associated service costs such as interest and fees.
This generalization, however, does not hold true for every company. This is because there can be times when a high equity multiplier reflects that the strategy of the company that makes it more profitable allows it to purchase or acquire assets at a lower cost.
Another interpretation could be that an equity multiplier of 2 means that half of the company’s assets are financed with debt while the other half is financed with shareholders’ equity.
The equity multiplier is a relevant factor in the DuPont analysis which is a method of financial analysis that was devised by the chemical company for its internal financial review. The DuPont model breaks the return on equity (ROE) calculation into three ratios; asset turnover ratio, net profit margin, and equity multiplier.
If there is a change in ROE or divergence from normal levels for the peer group over time, the DuPont analysis can indicate how much one can attribute it to the use of financial leverage. If there is a fluctuation in the equity multiplier, this can have a significant effect on ROE.
All other factors being equal, higher financial leverage, that is a higher equity multiple drives ROE upward.
Advantages of equity multiplier
- Indicates financial strength
- Indicates financial risk
Indicates financial strength
The equity multiplier indicates the financial strength of a company. It measures the extent to which a company uses shareholders’ equity to finance its assets. If the ratio is high, it implies that the company uses a higher amount of debt to finance its assets. A higher level of debt implies a lower level of financial strength.
Indicates financial risk
This financial metric helps to determine the financial risk of a company. A higher debt burden implies a greater risk of insolvency. Because of this, investors and creditors prefer to invest in and lend to companies with a lower equity ratio.
Disadvantages of equity multiplier
- Accelerated depreciation
- Negative working capital
These are the issues that are bound to dilute the use of equity multiplier for analysis. Therefore, it is advisable to take cautionary measures as well as use the equity multiplier alongside other financial metrics.
Due to the equity multiplier, the total assets show a smaller figure, so the metric is skewed.
Negative working capital
Since debt is referring to all liabilities including bills payable, in the case of negative working capital, there are assets that are financed by capital having no cost. In this case, the general interpretations fail.
Is a higher equity multiplier better?
Since a higher equity multiplier indicates higher financial leverage, it is generally better to have a lower equity multiplier. This is because a lower multiplier means that the company is not using excessive debt to finance its assets.