What is Equity Multiplier?
Equity multiplier is a leverage ratio that measures the portion of company’s assets that are financed by equity. It is calculated by dividing the company’s total assets by the total shareholder equity. The equity multiplier is also used to indicate the level of debt financing that a firm has used to acquire assets and maintain operations. A high multiplier indicates that a significant portion of a firm’s assets are financed by debt, while a low multiplier shows that either the firm is unable to obtain debt from lenders or the management is avoiding the use of debt to purchase assets.
Like other financial leverage ratios, the equity multiplier can show the amount of risk that a company poses to creditors. In fact, creditors and investors interested in investing in a company use this ratio to determine how leveraged a company is. For example, a company that relies too heavily on debt financing will incur high debt service charges and will be forced to raise additional cash flows to meet its obligations or maintain its operations. The company may also be unable to obtain further financing to expand its market reach.
When a firm is primarily funded using debt, it is considered highly leveraged, and therefore investors and creditors may be reluctant to advance financing to the company. A higher asset to equity ratio shows that the current shareholders own fewer assets that the current creditors. A lower multiplier is considered more favorable because such companies are less dependent on debt financing and do not need to use additional cash flows to service debts like highly leveraged firms do.
To explain leverage analysis, we use the example of Apple Inc. and Verizon Communications Inc. In March 2016, Apple’s total assets stood at $305 billion while the value of the shareholder’s equity stood at $130 billion. The equity multiplier ratio, in this case, is 2.346 ($305/$130). As of March 2016, Verizon’s total assets were $245 billion while the value of shareholder equity stood at $19 billion. The equity multiplier ratio for Verizon is 12.895 ($245/$19).
Apple’s equity multiplier ratio is lower than Verizon’s. Apple, an established and successful blue-chip company, enjoys less leverage and can comfortably service its debts. Due to the nature of its business, Apple is more vulnerable to evolving industry standards than other telecommunications companies. 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.
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.
ABC Company is an internet solutions company that supplies and installs internet cables in homes and business premises. The owner, Jake Caufield, 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 x 100). The company’s asset financing structure is conservative, and therefore, creditors would be willing to advance debt to ABC Company.
Calculating the Debt Ratio Using the Equity Multiplier
Both the debt ratio and equity multiplier are used to measure a company’s level of debt. Companies finance their assets through debt and equity, which form the foundation of both formulas.
Total Capital = Total Debt + Total Equity
The debt ratio refers to the proportion of company’s assets that are financed through debt. It is calculated as follows:
Debt Ratio = Total Debt / Total Assets
Using the example of ABC Company, 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 determine the debt ratio of a company using the following formula:
Debt Ratio = 1 – (1/Equity Multiplier)
Debt Ratio = 1 – (1/1.25) = 1 – (0.8) = 0.2 or 20%
DuPont Analysis is a financial assessment method developed by DuPont Corporation for internal review purposes. The DuPont model breaks down return on equity (ROE) into three constituents, which include the net profit margin, asset turnover, and equity multiplier. ROE measures the net income earned by a firm for its shareholders. When the value of the ROE changes over time, DuPont analysis shows how much of this change is attributable to financial leverage. Any changes in the value of equity multiplier result in changes in the value of ROE. The ROE formula is written as follows:
ROE = Net Profit Margin x Total Assets Turnover Ratio x Financial Leverage Ratio
ROE = [Net Income / Sales] x [Sales / Average Total Assets] x [Average Total Assets / Average Shareholder’s Equity]
The Relationship between ROE and EM
In the formula above, there is a direct relationship between ROE and the equity multiplier. Any increase in the value of the equity multiplier results in an increase in ROE. A high equity multiplier shows that the company incurs a higher level of debt in its capital structure and it reduces the overall cost of capital.
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