Equity Multiplier

The equity multiplier is a risk indicator that measures the portion of a company’s assets that is financed by stockholders’ equity rather than by debt. It is calculated by dividing a company’s total asset value by its total shareholder’s equity.

Generally, a high equity multiplier indicates that a company is using a high amount of debt to finance assets. A low equity multiplier means that the company has less Reliance on debt.

However, a company’s equity multiplier can be seen as high or low only in comparison to historical standards, the averages for the industry, or the company’s peers.

The equity multiplier is also known as the leverage ratio or financial leverage ratio and is one of three ratios used in the Dupont analysis.

DuPont Analysis

DuPont Analysis is a financial assessment method developed by DuPont Corporation for internal review purposes.

The DuPont model breaks down return on equity into three constituents, which include the net profit margin, asset turnover, and equity multiplier.

Return on equity measures the net income earned by a firm for its shareholders. When the value of the return on equity changes over time, DuPont analysis shows how much of this change is attributable to financial leverage.

Any changes in the value of the equity multiplier result in changes in the value of return on equity. The return on equity formula is written as follows :

ROE = Net Profit Margin × Total Assets Turnover Ratio × Financial Leverage Ratio

The equity multiplier reveals how much of the total assets are financed by shareholders’ equity. Essentially, this ratio is a risk indicator used by investors to determine how leveraged the company is.

  • The equity multiplier is a measure of the portion of the company’s assets that is financed by stock rather than debt.
  • Generally, a high equity multiplier indicates that a company has a higher level of debt.
  • Investors judge a company’s equity multiplier in the context of its industry and its peers.

A high equity multiplier indicates that a company is using a large amount of debt to finance assets. Companies with the highest debt burden will have higher debt servicing costs, which means that they will have to generate more cash flow to sustain a healthy business.

A low equity multiplier implies that the company has fewer debt-financed assets. That is usually seen as a positive as its debt servicing cost or lower.

But it could also signal that the company is unable to entice lenders to loan it money on favorable terms, which is a problem.

Equity Multiplier Formula

The equity multiplier formula is calculated as follows :

Equity Multiplier = Total Assets / Total Shareholder’s Equity

The values for the total Assets and the shareholder’s equity are available on the balance sheet and can be calculated by anyone with access to the company’s annual financial reports.

Example:-

ABC company is an internet Solution company that supplies and installs internet cables in homes and business premises.

The owner X, wants the company to go public in the next year so that they can sell shares of the company to the public.

However,  before going public, the company wants to know if its current equity multiplier ratio is healthy enough to attract creditors.

The previous year’s reports indicate that the company owns $ 1,000,000 in total Assets and shareholder’s equity stands at  $ 800,000. The equity multiplier ratio for ABC company is calculated as follows :

Equity Multiplier = $ 1,000,000 / $ 800,000

                           = 1.25

ABC company reports a low equity multiplier ratio of $ 1.25. It shows that the company faces less leverage since a large portion of the assets are financed using equity, and only a small portion is financed by debt.

ABC company only uses 20% debt to finance the assets [(1,000,000 – 800,000) / 1,000,000 × 100)]. The company’s asset financing structure is conservative and therefore creditors would be willing to advance debt to ABC company.

What is a good equity ratio?

Generally, a business wants to shoot for an equity ratio of about 0.5 or 50%, which indicates that there is more outright ownership in the business than debt. In other words, more is owned by the company itself than creditors.

Advantages and Disadvantages of Equity Multiplier

Both higher and lower equity multipliers can have their share of benefits and disadvantages.

Higher Equity Multiplier

High debt proportion in capital structure may have the following issues –

  • Higher debt means  a higher risk of insolvency. If the profits decline under any circumstances, the chances of not meeting the financial and other obligations increase.
  • The ability to borrow more debt becomes tough since it already leveraged high.

Lower Equity Multiplier

On the other hand, lower Equity Multiplier can signify inefficiency in creating value for shareholders by way of tax benefits due to leverage.

Ideal Equity Multiplier

There can’t be one ideal equity multiplier. It should be part of the overall strategy of the business. This may depend a lot on industry and other factors such as availability of debt, size of the project, etc.

Problem with the Equity Multiplier

The ratio can be skewed or misunderstood in several ways. First, if an organization uses accelerated depreciation since doing so artificially reduces the number of total assets used in the numerator.

Second, if the ratio is high, the assumption is that a large amount of debt is being used to fund payables. However, the organization may instead be delaying the payment of its accounts payable in order to fund the assets. If so, the entity is at risk of having its credit cut off by suppliers, which could trigger a rapid decline in its liquidity.

Third, if a business is highly profitable, it can fund most of its assets with on-hands funds, and so has no need for debt funding.

This concept only applies if excess funds are not being distributed to shareholders in the form of dividends or stock repurchases.

And finally, if an organization conducts a large part of its billings at a certain time of the month this can skew the total assets figure upward, due to a large increase in accounts receivable.


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