Table of Contents Hide
- What is the Equity Multiplier?
- Understanding the Equity Multiplier
- The formula for Equity Multiplier
- Investors’ Perceptions of the EM
- Using the Equity Multiplier to Calculate the Debt Ratio
- Relationship Between ROE and EM
- High vs Low Equity Multiplier
- The Importance and Application of the Equity Multiplier Formula
- Excel Equity Multiplier Formula (With Excel Template)
- Equity Multiplier Benefits and Drawbacks
- Equity Multiplier FAQs
- What does an equity multiplier of 2.5 mean?
- Is higher equity multiplier better?
- What is a good ROE?
The equity multiplier, like all liquidity and financial leverage ratios, indicates the company’s risk to creditors. Companies that rely too heavily on debt financing will face high debt service costs and will need to generate more cash flows to cover their operations and obligations. Here let’s look at how to calculate the equity multiplier with the formula and an excel template.
What is the Equity Multiplier?
The equity multiplier is the ratio of a company’s total assets to the equity of its stockholders. The ratio is designed to assess how much equity is used to pay for all types of company assets. There is no perfect EM level because it varies by industry, the amount of collateral available, and the lending environment. A high ratio indicates that assets are being funded with a high proportion of debt. In contrast, a low ratio indicates that management is either avoiding the use of debt or that the company is unable to obtain debt from prospective lenders. A high equity multiplier, especially when compared to the results of other companies in the same industry, indicates that a company may have incurred more debt than is typical, which may be difficult to support if the business cycle is in a downward trend.
Understanding the Equity Multiplier
The EM can tell you a lot about a company and the level of risk it poses to investors.
Investment in assets is a critical component of business activities, and companies must finance this acquisition through debt, equity, or a combination of the two.
The EM indicates how much of a company’s assets are financed by shareholder equity. Investors frequently use this ratio to find how leveraged a company is. When a company’s EM exceeds the average for its industry and peers, it indicates that the company is using more debt to finance its assets. A higher debt burden frequently equates to higher debt servicing costs and a greater need for cash flow to sustain business operations.
In general, a lower EM indicates that a company uses less debt to finance its assets. This is frequently viewed positively by investors. It may, however, indicate that a company is unable to obtain debt financing on reasonable terms, which is a serious problem.
The formula for Equity Multiplier
The equity multiplier formula is as follows:
The balance sheet shows the total assets and shareholder equity values, which can be calculated by anyone with access to the company’s annual financial reports.
ABC Company is a provider of internet solutions that supplies and installs internet cables in homes and businesses. Jake Caufield, the company’s owner, wants the company to go public within the next year so that it can sell shares to the general public. However, the company wants to know if its current equity multiplier ratio is healthy enough to attract creditors before going public. According to previous year’s reports, the company has $1,000,000 in total assets and $800,000 in shareholder equity. ABC Company’s equity multiplier ratio is calculated as follows:
$1,000,000 / $800,000 = 1.25 Equity Multiplier
ABC Company has a $1.25 EM ratio. It demonstrates that the company faces less leverage because a large portion of the assets are financed with equity and only a small portion with debt. ABC Company finances its assets with only 20% debt [(1,000,000 – 800,000) / 1,000,000 x 100]. Because ABC Company’s asset financing structure is conservative, creditors would be willing to advance debt to the company.
Investors’ Perceptions of the EM
There is no such thing as an ideal EM. It will differ depending on the sector or industry in which a company operates.
An equity multiplier of 2 indicates that half of the company’s assets are financed with debt and the other half with equity.
So, the EM is a key factor in DuPont analysis, a financial assessment method developed by the chemical company for internal financial review. The DuPont model divides return on equity (ROE) calculation into three ratios: net profit margin (NPM), asset turnover ratio, and equity multiplier.
If ROE fluctuates or deviates from normal levels for the peer group, the DuPont analysis can determine how much of this is due to the use of financial leverage. If the equity multiplier fluctuates, it can have a significant impact on ROE.
All other factors being equal, higher financial leverage (i.e. a higher equity multiple) drives ROE upward.
Using the Equity Multiplier to Calculate the Debt Ratio
The debt ratio and equity multiplier are both used to calculate a company’s debt level. Companies finance their assets with debt and equity, which are the pillars of both formulas.
The debt ratio is the percentage of a company’s assets that are financed by debt. It is determined as follows:
Using ABC Company as an example, the debt ratio is calculated as follows:
Debt Ratio = 200,000/1,000,000 = 0.2, or 20%
We can also use the equity multiplier to calculate a company’s debt ratio using the following formula:
Debt Ratio = 1 – (1/1.25) = 1 – (0.8) = 0.2, or 20%
The DuPont Analysis and the Equity Multiplier
The EM is one of the ratios that comprise the DuPont analysis, which is a framework for calculating a company’s return on equity (ROE).
The equity multiplier is multiplied by the net profit margin and asset turnover in the three-step DuPont analysis variation.
DuPont Analysis Formula in Three Steps
- DuPont Analysis = Net Profit Margin Asset Turnover Equity Multiplier
- Net Profit Margin = Revenue / Net Income
- Turnover of Assets = Revenue * Average Total Assets
- Average Total Assets x Average Shareholders’ Equity = Equity Multiplier
Revenue and net income are income statement metrics, which means they are measured over time, whereas assets and equity are balance sheet metrics, which are carrying values at a specific point in time.
The average balance is used to match the timing of the denominator and numerator in all three ratios (i.e. between the beginning and end of period value for balance sheet metrics).
Relationship Between ROE and EM
There is a direct relationship between ROE and the equity multiplier in the formula above. So, any increase in the value of the EM raises the ROE. A high EM indicates that the company incurs more debt in its capital structure while having a lower overall cost of capital.
High vs Low Equity Multiplier
Higher equity multipliers typically indicate that the company uses a high percentage of debt in its capital structure to fund working capital and asset purchases.
All else being equal, increased reliance on debt financing results in increased credit risk.
A low EM on the other hand, indicates that the company is less reliant on debt (and reduced default risk).
As a result, a lower EM is typically perceived as better, because the company relies more on equity contributed by owners (e.g., founders, institutional investors) as well as retained earnings.
If the equity multiplier is “low,” the company is either unable to obtain debt from lenders or is avoiding the use of debt on purpose – so continued operations are a positive signal that the current equity capital on hand and retained earnings are sufficient.
So, if the multiplier is “high,” the company’s operations and asset purchases are primarily financed by debt, putting it at risk of default.
However, as with almost all financial metrics, whether a company’s equity multiplier is high (or low) is determined by the industry average and that of comparable peers.
Another exception is for mature, established companies with high debt capacities, as access to financing with favorable lending terms is one of the company’s “economic moats” (and ability to purchase inventory from suppliers at lower prices due to buying power).
The Importance and Application of the Equity Multiplier Formula
- The Equity Multiplier Formula informs investors about whether a company invests more in equity or debt.
- A higher EM ratio indicates that the company is heavily reliant on debt for funding. It also implies that investing in such a company would be risky.
- When a company is primarily funded by equity and debt, the equity multiplier ratio is also low. While the multiplier ratio is low, the company lacks financial leverage to build more in the future because the future is uncertain. The concept of EM is critical in balancing both equity ratio and debts.
- The equity multiplier formula is most commonly used to assess a company’s financial strength. This formula produces an increased or decreased equity multiplier ratio. A higher level of debt or leverage indicates that the company is approaching the risky territory.
- For the financial leverage portion of the DuPont analysis, the equity multiplier formula is part of the return on equity DuPont formula.
Excel Equity Multiplier Formula (With Excel Template)
In this example, we will use the Equity Multiplier formula in Excel. It is extremely simple. Total Assets and Total Shareholders’ Fund must be entered as inputs.
The Equity Multiplier formula is easily calculated using the provided template.
To find the Equity Multiplier, we must first find the Total Assets and Total Shareholders’ Fund.
Because the total asset value is not given in the first example, we must first calculate Total Assets. i.e
Total Assets is 200 in the second example, and Total Equity is 40. So, we use a formula to directly calculate the equity multiplier.
Total assets are the sum of current and non-current assets.
So, here we directly calculate the equity multiplier using the formula
Equity Multiplier Benefits and Drawbacks
Both higher and lower EM can have advantages and disadvantages.
#1. Greater EM
The following issues may arise as a result of a high debt proportion in the capital structure:
Higher debt levels indicate a higher risk of insolvency. If profits fall under any circumstances, the likelihood of failing to meet financial and other obligations rises.
Because the debt is already heavily leveraged, borrowing more debt becomes difficult.
#2. Reduced EM
Lower EM, on the other hand, may indicate inefficiency in creating value for shareholders through tax benefits due to leverage.
#3. The Ideal EM
There can’t be a single perfect EM. It should be part of the overall business strategy. This is highly dependent on the industry and other factors such as debt availability, project size, and so on.
Issues with the Equity Multiplier Metric
Certain issues can taint the use of the EM for analysis. Precautionary measures are recommended.
- Accelerated Depreciation
As a result, total assets show a lower figure, skewing the metric.
- Working Capital Deficit
Because the definition of debt in this context includes all liabilities, including payables. As a result, in the case of negative working capital, there are assets financed by capital with no cost. The general interpretations fail here.
- Profitable Finance
Highly profitable businesses may not pay out large dividends to shareholders and may use profits to finance the majority of their assets. The metric has little meaning.
- Seasonal Enterprise
Seasonal businesses typically do the majority of their business in one quarter of the year, say Q1. Equity multipliers for the first and third quarters will produce different results for the metric.
Equity Multiplier FAQs
What does an equity multiplier of 2.5 mean?
This means that the company’s assets are worth 2.5 times its stockholders’ equity, which suggests that, depending on the industry, the company may be using too much leverage.
Is higher equity multiplier better?
A higher asset to equity ratio indicates that current shareholders own fewer assets than current creditors. A lower multiplier is considered more favorable because such companies are less reliant on debt financing and do not need to use additional cash flows to service debts as highly leveraged firms do.
What is a good ROE?
An ROE, like a return on capital, measures management’s ability to generate income from the equity that is available to it. ROEs of 15–20% is generally regarded as good.