Table of Contents Hide
- What is Equity Multiplier?
- How to Interpret the Equity Multiplier
- Investors’ Perceptions of the Equity Multiplier
- The formula for Equity Multipliers
- Other Examples Using the Equity Multiplier Formula
- Equity Multiplier Formula Low and High
- Using the Equity Multiplier to Calculate the Debt Ratio
- Role of EM in Relation to ROE
- Equity Multiplier Benefits and Drawbacks
- Equity Multiplier Formula FAQs
- How do you calculate the equity multiplier?
- What does equity multiplier ratio mean?
- What does an equity multiplier of 2.5 mean?
- Related Articles
The formula to calculate equity multiplier is stated as follows: Total Assets/Total Shareholder Equity. Anyone with access to the company’s yearly financial reports can compute the values of the total assets and the shareholder’s equity from the balance sheet.
But before going any further, let’s find out what exactly an equity multiplier is in real estate and how to calculate it.
What is Equity Multiplier?
In simple terms, the equity multiplier gauges how much of the company’s assets are financed by equity. As earlier mentioned, it is computed by dividing the company’s total assets by the total equity held by shareholders. The equity multiplier can also be used to show how much debt financing a company has used to make purchases and fund ongoing operations. A high multiplier implies that a large percentage of a company’s assets are financed by debt, whereas a low multiplier suggests that the company is either unable to secure funding from lenders or that management is avoiding using debt to buy assets.
The equity multiplier, like other financial leverage ratios, demonstrates how much risk a corporation poses to creditors. In fact, this ratio is used by creditors and potential investors to assess a company’s level of leverage. For instance, a business that depends too much on debt financing would face significant debt service costs and be obliged to find new sources of cash flow in order to pay its debts and continue operating. Additionally, the business might have trouble securing additional funding to broaden its market.
How to Interpret the Equity Multiplier
The secret to operating a successful firm is to invest in assets. Companies issue equity, debt, or a mixture of the two to pay for the acquisition of assets.
So, how much of the total assets are financed by shareholders’ equity is shown by the equity multiplier. In reality, investors use this ratio as a risk indicator to gauge how indebted the firm is.
Furthermore, an organization is employing a significant amount of debt to finance assets if its equity multiplier is high (compared to historical norms, industry averages, or competitors). Increased debt loads will result in higher debt service expenses for businesses, which means they will need to produce more cash flow to maintain a healthy operation.
A low equity multiplier, on the other hand, suggests that the business has fewer assets that were financed with debt. Since its debt servicing expenses are lower, this is typically viewed as a good. However, it could also be a concern if it shows that the business is unable to convince lenders to give it a loan with favorable terms.
Investors’ Perceptions of the Equity Multiplier
An Ideal equity multiplier does not exist. The sector or industry that a corporation operates in will determine the specifics.
A two-fold equity multiplier indicates that half of the company’s assets are financed by debt and the other half by equity.
Meanwhile, in DuPont analysis, a technique for evaluating financial performance developed by the chemical firm for its internal financial review, the equity multiplier plays a significant role. The net profit margin (NPM), asset turnover ratio, and equity multiplier are the three measures used by the DuPont model to calculate return on equity (ROE).
The DuPont analysis can show how much any changes in ROE over time or deviations from peer group averages can be attributed to the usage of financial leverage. ROE may be severely impacted if the equity multiplier changes.
All other things being equal, increased financial leverage (i.e., a larger equity multiple) increases ROE.
The formula for Equity Multipliers
As earlier mentioned, the formula for calculating the equity multiplier is total assets divided by stockholder equity.
Applying the Equity Multiplier Formula
For the financial leverage part of the DuPont analysis, the return on equity calculation uses the equity multiplier formula. Financial analysis generally uses financial leverage to assess a company’s usage of debt.
It should be noted that in finance, a company’s assets equal debt + equity, which will help you comprehend how the equity multiplier formula relates to debt.
The equity multiplier method does not directly include debt, but it is an underlying element because debt is included in the total assets in the numerator of the equity multiplier formula. This can be demonstrated by rewriting the equity multiplier formula’s total assets as debt plus equity.
Alternative Formula for Equity Multiplier
The reciprocal of the equity ratio serves as a substitute formula for the equity multiplier. As was previously stated, a company’s assets are equal to its debt plus equity. As a result, the equity ratio determines how much of a company’s assets are in equity.
One less than the debt ratio can also be used to find the ratio in the denominator of the formula.
Analysis of Leverage
When a company is predominantly financed by debt, it is said to be highly leveraged, and creditors and investors may be hesitant to provide additional financing to the business. A higher asset to equity ratio indicates that the existing debtors and shareholders own different amounts of assets. And because these businesses rely less on debt financing and do not have to generate additional cash flows to pay off debt, as do highly leveraged businesses; a lower multiplier is viewed as more beneficial.
We employ the cases of Apple Inc. and Verizon Communications Inc. to illustrate leverage analysis. Apple’s total assets were $305 billion in March 2016, while the shareholder stock was worth $130 billion. In this instance, the equity multiplier ratio is 2.346 ($305/$130). Verizon had $245 billion in total assets as of March 2016 and $19 billion in shareholder equity. Verizon has an equity multiplier ratio of 12.895 ($245/$19).
Apple has a lower equity multiplier ratio than Verizon. Apple, a reputable and flourishing blue-chip business, has less leverage and is able to easily pay off its obligations. Because of the nature of its operations, Apple is more susceptible to changing industry standards than other telecom firms. On the other hand, Verizon’s multiplier risk is high, meaning that it is heavily dependent on debt financing and other liabilities. The company’s proportion of equity is low, and therefore, depends mainly on debt to finance its operations.
Other Examples Using the Equity Multiplier Formula
Total Assets / Total Shareholder Equity = Equity Multiplier
ABC Firm is an internet solutions company that distributes and installs internet lines in households and corporate premises. The owner, Jim Duran, wants the company to go public in the next year so that they can sell shares of the company to the public. However, the business needs to know if its present equity multiplier ratio is sound enough to draw investors before going public. According to statistics from the prior year, the corporation has $800,000 in shareholder stock and $1,000,000 in total assets. The ABC Company’s equity multiplier ratio is determined as follows:
Equivalent Multiplier = 800,000/$1,000,000 = 1.25
The equity multiplier ratio for ABC Company is only $1.25.
Since a sizable share of the assets is financed with equity and just a tiny portion with debt, it demonstrates that the corporation confronts less leverage.
Basically, only 20% of the assets are financed by debt at ABC Company [(1,000,000 – 800,000) / 1,000,000 x 100]. Creditors would be prepared to advance debt to ABC Company because of the company’s conservative asset financing structure.
Equity Multiplier Formula Low and High
Investors typically opt for organizations with a low equity multiplier since this shows the business is financing the acquisition of assets with more equity and less debt. High debt loads could indicate financially risky companies. This is especially true if the business starts to have trouble producing the cash flow from operating activities (CFO) required to pay down the debt and the expenditures involved in its servicing, such as interest and fees.
This generalization does not apply to all businesses, though. A company’s strategy that makes it more lucrative and enables it to buy assets at a reduced cost may occasionally be reflected by a large equity multiplier.
Calculating the Equity Multiplier of a Company
The equity multiplier is an indicator of a company’s financial leverage, or the sum of loans it has taken out to pay for the acquisition of assets, is the equity multiplier. The following equation can be used to determine a company’s equity multiplier:
Total assets / Total stockholders' equity
Divide the entire assets of the company by the total stockholder equity, sometimes referred to as shareholders’ equity, to arrive at the equity multiplier.
A smaller equity multiplier suggests less financial leverage for the organization. A low equity multiplier is preferable in general since it indicates that a business is not taking on too much debt to finance its assets. Instead, the corporation issues shares to pay for the acquisition of the assets required to run its operations and enhance its cash flows.
Investors can use the equity multiplier to contrast businesses in the same industry or evaluate a particular business against the benchmark when comparing several businesses as potential investments.
Let’s say that business ABC has $2 million in stockholders’ equity and $10 million in total assets. ($10 million divided by $2 million) equals a 5 equity multiplier. This indicates that firm ABC finances 20% of its assets through the stock and the balance 80% through debt.
On the other hand, firm DEF, which belongs to the same industry as business ABC, has $20 million in total assets and $10 million in stockholders’ equity. ($20 million divided by $10 million) equals a 2x equity multiplier. This indicates that the company DEF finances 50% of its assets through the stock and 50% through debt.
The equity multiplier of company ABC is bigger than that of firm DEF, showing that ABC is borrowing more money to pay for its assets.
Because it shows the business is using less debt to purchase assets, a smaller equity multiplier is desired. In this situation, business DEF is preferable over company ABC since it carries less risk due to its lower debt load.
Using the Equity Multiplier to Calculate the Debt Ratio
A company’s level of debt is determined using both the debt ratio and the equity multiplier. Debt and equity, which are the cornerstones of both formulas, are how businesses fund their assets.
Total Capital is the sum of all debt and all equity.
The percentage of a company’s assets that are financed by debt is known as the debt ratio.
The formula is as follows:
Debt Ratio = Total Debt / Total Assets
The following formula is used to compute the debt ratio using the example of ABC Company:
Debt Ratio = 200,000/1,000,000. This equals 0.2 or 20%.
The following formula can be used to calculate a company’s debt ratio using the equity multiplier:
Debt Ratio = 1 - (1 / Equity Multiplier)
DuPont Analysis: Debt Ratio = 1 - (1/1.25) = 1 - (0.8) = 0.2 or 20%
A financial evaluation technique called the DuPont Analysis was created by the DuPont Corporation for internal review purposes. The net profit margin, asset turnover, and equity multiplier are the three components that make up the DuPont model’s breakdown of return on equity (ROE).
Net income that a company generates for its shareholders is measured by ROE. DuPont analysis reveals how much of a change in the ROE’s value can be attributed to financial leverage over time. The value of ROE fluctuates whenever the equity multiplier’s value changes. The ROE formula looks like this:
Equity Return = Equity Total Asset Turnover Ratio x Financial Leverage Ratio x Net Profit Margin
Return on Equity = Average Total Assets/Average Shareholder's Equity + [Net Income/Sales] x [Sales/Average Total Assets]
Role of EM in Relation to ROE
The equity multiplier and ROE have a direct relationship in the model above. The equity multiplier’s value must increase for the ROE to increase. A high equity multiplier indicates that the company has a lower total cost of capital and more debt in its capital structure.
Equity Multiplier Benefits and Drawbacks
Both EM levels, higher and lower, might have advantages and drawbacks.
Higher Equity Multiplier
The following problems may result from a capital structure with a high debt proportion.
Insolvency risk increases with debt levels. Any decrease in profits increases the likelihood of failing to fulfill financial and other responsibilities.
Given the high level of leverage, it becomes difficult to borrow further debt.
Lower Equity Multiplier
On the other hand, lower EM may indicate ineffectiveness and a lack of ability to generate funds for shareholders through tax advantages brought on by leverage.
Good Equity Multiplier
A perfect equity multiplier does not exist. It ought to be incorporated into the company’s overarching plan. This may vary greatly depending on the industry and other factors like the size of the project, the accessibility of loans, etc.
Equity Multiplier Formula FAQs
How do you calculate the equity multiplier?
The following formulas will help to calculate equity multiplier;
- Equity Multiplier = Total Assets / Total Shareholder’s Equity.
- Total Capital = Total Debt + Total Equity.
- Debt Ratio = Total Debt / Total Assets.
- Debt Ratio = 1 – (1/Equity Multiplier)…
What does equity multiplier ratio mean?
A financial leverage ratio known as the equity multiplier compares total assets to total shareholder equity to determine how much of a company’s assets are financed by its owners. The equity multiplier, in other words, displays the proportion of assets that are financed or owed by the shareholders.
What does an equity multiplier of 2.5 mean?
This indicates that, depending on the industry, the corporation may be using too much leverage. This is because the assets are worth 2.5 times the stockholders’ equity.