What is the Equity Multiplier
The equity multiplier is a financial leverage ratio. It measures a firm’s assets that are financed by its shareholders. It does this by comparing total assets with total shareholder’s equity. In other words, the equity multiplier shows the percentage of assets that are financed or owed by the shareholders. At the same time, this ratio also shows the level of debt financing that is used to acquire assets and maintain operations.
Like all liquidity ratios and financial leverage ratios, the equity multiplier is an indication of company risk to creditors. Companies that rely too heavily on debt financing will have higher debt service costs. They have to raise more cash in order to pay for their operations and obligations. Both creditors and investors use this ratio to measure how much debt, or leverage a company uses.
Equity Multiplier Formula
The equity multiplier formula is calculated by dividing total assets by total stockholder’s equity. Both of these accounts are easily found on the balance sheet.
Equity Multiplier = Total Assets / Shareholder Equity
Equity Multiplier Analysis
The equity multiplier is a ratio used to analyze a company’s debt and equity financing strategy. A higher ratio means that more assets were funded by debt than by equity. In other words, investors funded fewer assets than creditors. When a firm’s assets are primarily funded by debt, the firm is considered to be highly leveraged and riskier for investors and creditors. This also means that current investors actually own less of the company assets than current creditors.
Lower multiplier ratios are considered more conservative and more favorable than higher ratios. This is because companies with lower ratios are less dependent on debt financing. As a result, they don’t have high debt servicing costs. The multiplier ratio is also used in the DuPont analysis to illustrate how leverage affects a firm’s return on equity. Higher multiplier ratios tend to deliver higher returns on equity according to DuPont analysis.
What is 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 (ROE) into three constituents. They are 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 the equity multiplier result in changes in the value of ROE.
The Equity Multiplier – Digging Deeper
Investment in assets is key to running a successful business. Companies finance their acquisition of assets by issuing equity or debt, or some combination of both. 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. It helps to reveal how leveraged the company is.
- A high equity multiplier (relative to historical standards, industry averages, or a company’s peers) indicates that a company is using a large amount of debt to finance assets. Companies with a higher debt burden will have higher debt servicing costs. This 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 costs are lower. But it could also signal that the company is unable to entice lenders to loan it money on favorable terms. Always use caution when interpreting investment data.
Which is Better – High or Low?
In general, investors look for companies with a low multiplier. This indicates the company is using more equity and less debt to finance the purchase of assets. Companies that have a high debt burden could be financially risky. This is particularly true if the company begins to experience difficulty in generating the cash flow. Operating activities are needed to repay the debt and the associated servicing costs, such as interest and fees. However, this generalization does not hold true for all companies. There can be times when a high equity multiplier reflects a company’s deliberate strategy. Sometimes, leverage makes it more profitable and allows it to purchase assets at a lower cost.
Equity Multiplier Example
ABC company works with local companies in the area for maintenance and repair. ABC Co is looking to bring the company public in the next year. To this end, the company wants to make sure the equity multiplier ratio is favorable. According to ABC Co’s financial statements, the company has $1,500,000 of total assets. The company lists $1,200,000 in total equity. ABC’s multiplier is calculated like this:
Equity Multiplier = 1,500,000/1,200,000 = 1.25
As you can see, ABC Co has a ratio of 1.25. This means that the company’s debt levels are quite low. Only 25 percent of the assets are financed by debt. Conversely, investors finance 75 percent of his assets. This makes Tom’s company conservative as far as creditors are concerned. However, the return on equity will be negatively affected by this low ratio.
Real Life Equity Multiplier Ratio Examples
The equity multiplier ratio will vary from industry to industry. Therefore, it is important to compare equity multiplier ratios based on similar industries. To illustrate this difference, the following calculations are based on Apple Inc. and Amazon balance sheets.
Apple: Assets $207,000, Equity $123,549 Equity Multiplier = 1.68
Amazon: Assets $ 40,159, Equity $9,746 Equity Multiplier = 4.12
The equity multiplier of Amazon (4.12) is significantly higher than Apple (1.68) indicating that Amazon is more highly leveraged than Apple.
Problems Interpreting the Equity Multiplier
The ratio can be skewed or misunderstood in the following ways:
- Depreciation – If an organization uses accelerated depreciation, it can artificially reduce the total assets used in the numerator.
- Payables – 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. This could trigger a rapid decline in its liquidity.
- Profitability – If a business is highly profitable, it can fund most of its assets with on-hand funds. As a result, it has no need for debt funding. This concept only applies if excess funds are not being distributed. For example, distribution to shareholders in the form of dividends or stock repurchases.
- Timing – If an organization conducts a large part of its billings at a certain time of the month. For example, at the month-end. This can skew the total assets figure upward, due to a large increase in accounts receivable.
The equity multiplier can be a useful tool in analyzing risk. A company that leverages more debt to finance itself is taking on more liabilities. There are corresponding debt payments that have to be made that don’t add to the business. Whereas financing with equity can be put more fully into business activities. It also cuts down on the risks of debt payments and defaults. This can occur when profits decrease to a point where making payments is difficult.
However, for some companies, a high equity multiplier does not always equate to higher investment risk. High use of debt can be part of an effective business strategy that allows the company to purchase assets at a lower cost. This is sometimes the case when the company finds it is cheaper to incur debt as a financing method compared to issuing stock.
Investors usually look for conservative, low-risk plays. For that reason, a company with a low equity multiplier is usually the way to go. But, keep in mind that companies with high equity multipliers are not always bad investments. For example, if there is a special economic situation where a competitor’s valuation is cheap relative to its performance. A company might use debt in this situation to acquire that competitor. The result can boost their profits at a higher rate than the debt they incur. Of course, there’s still a risk. But in this case, it’s a strategic risk.
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