What is Equity Multiplier?
What is the formula and what does it measure?
What are the essential elements you should know!
In this article, we will break down the financial definition of Equity Multiplier so you know all there is to know about it!
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What Is Equity Multiplier
The equity multiplier (also referred to as “EM” or “leverage ratio”) is a financial indicator allowing you to assess the proportion of a company’s assets acquired through equity as opposed to debt.
In essence, by calculating a company’s equity multiplier or looking at its equity multiplier ratio, a business stakeholder, investor, or lender is looking to measure the company’s risk profile.
The higher the asset to equity ratio, the more a company is leveraged through debt.
The lower the asset over equity ratio, the more a company is financed through the issuance of equity and thus relies less on debt.
To have a better perspective of a company’s risk profile, the equity multiplier is generally considered in comparison to the company’s historical performance.
The company’s EM ratio can also be compared to industry peers, the industry average, or even a specific market segment.
Equity Multiplier Definition
According to Investopedia, the equity multiplier is defined as:
The equity multiplier is a risk indicator that measures the portion of a company’s assets that is financed by stockholder’s equity rather than by debt.
The definition is quite simple and can be summarized as follows:
- It’s a risk indicator
- Measures a company’s source financing through equity or debt
Equity Multiplier Formula
The equity multiplier formula is essentially a company’s total assets divided by the company’s total shareholders’ equity.
The formula can be depicted as follows:
Equity Multiplier = Total Assets / Shareholder Equity
The higher the “equity multiplier” the more a company is financed through debt.
The lower the asset over equity result, the less a company is financed through debt and is more financed through equity.
Equity Multiplier Ratio
Understanding the manner a business is financed is crucial for the business operators in running a profitable business and for investors to assess a company’s risk profile.
For companies to acquire assets and conduct business, they will need to either finance their activities by injecting their own equity, issuing debt, or any possible combination of the two.
In essence, the equity multiplier ratio is an indicator revealing how much a company has purchased its total assets through stockholder’s equity.
If the EM ratio results in a high number, it means that the company in question is financed more heavily using debt.
In other words, the company will need to generate a more consistent and steady profit to be able to meet its debt payment obligations (or debt service).
On the other hand, if a company’s EM is low, it means that the company does not have as many assets financed through debt.
This is positive news as the company’s debt servicing costs may be lower and the company will not need to have a minimum profitability to be able to meet its debt payments.
However, an investor may also deduce that the company may have difficulty raising debt which can be caused by poor credit or other factors preventing the company from taking on debt financing.
Calculate Equity Multiplier Example
Let’s calculate a company’s equity multiplier by using a fictional example to get a better sense of the financial concept.
Imaging that a company has a total asset of $1,000,000 on its balance sheet and $200,000 in shareholder’s equity.
The company’s equity multiplier is therefore $1,000,000 divided by $200,000 equalling 5.
This means that for every one dollar of equity, the company has four dollars of debt leverage.
This ratio can be compared to the company’s year-over-year progress or to the ratio of its direct competitors in its industry.
There’s no “good” or “bad” equity multiplier ratio.
Generally, this ratio is considered along with other ratios for an investor or individual to get an overall understanding of a company’s financial position.
Calculating Debt Ratio
You can use the “equity multiplier formula” or “equity multiplier ratio” to calculate a company’s debt ratio.
The debt ratio is a company’s total debt divided by its total assets.
The debt ratio formula can be depicted as follows:
Debt Ratio = Total Debt / Total Assets
To calculate the debt ratio using the equity multiplier measure, you can use the following formula:
Debt Ratio = 1 – (1 / Equity Multiplier)
With this equation, you can use the formula for equity multiplier to derive a company’s debt ratio.
The DuPont Analysis is named after the DuPont company who developed this financial assessment model.
The DuPont model breaks down return on equity (ROE) into three parts:
- Net profit margin
- Asset turnover
- Equity multiplier
DuPont can therefore calculate the impact on the company’s net income (ROE) based on variations to the equity multiplier.
Here is how the Return on Equity formula is depicted:
ROE = NPM X TATR X FLR
- ROE = Return on Equity
- NPM = Net Profit Margin
- TATR = Total Assets Turnover Ratio
- FLR = Financial Leverage Ratio
Leverage Multiplier Takeaways
So, what does equity multiplier mean?
How to calculate equity multiplier?
What does the equity multiplier measure?
Let’s look at a summary of our findings.
What Is The Equity Multiplier
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Related to Financial Ratios
Asset to equity ratio
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Debt-to-equity ratio (D/E)
Net profit margin (NPM)
Return on equity (ROE)
Shareholder equity ratio
Weighted average cost of capital (WACC)