Banking Financial Analysis Investment Markets

Equity multiplier

What is the Equity Multiplier?

Equity multiplier is a leverage ratio that measures the portion of the company’s assets that are financed by equity.

In other languages, then it is expressed the percentage of assets that are financed by the shareholders of a company.

It is calculated by dividing the company’s total assets by the total shareholder equity. It is also used to indicate the level of debt financing that a firm has used to acquire assets and maintain operations.

On the other hand, this ratio also represents the level of debt financing is used to acquire assets and continue 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

Advantage of equity multiplier

  • Analyze a company’s debt and equity financing strategy
  • Level of debt financing that a firm
  • Acquire assets and maintain operations
  • Shows financial retaining capacity of the company

 

A disadvantage of equity multiplier

 

  • Seasonal factors, depending on the business, can also be a significant contemplation, because these factors can disfigure ratios.

Read| Accounting Ratios

The formula of equity multiplier

The equity multiplier formula is calculated as follows:

Equity Multiplier formula

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.

Analysis and Interpretation of equity multiplier

A company wants to analyze its debt and equity financing strategy then this ratio is useful.

A higher ratio means that more assets were funded by debt than by equity. In simple language, investors funded lessor assets than by 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.

A higher ratio is less recommended for debt financing and doesn’t have high debt servicing costs.

The multiplier ratio is additionally utilized in DuPont analysis for example how leverage affects a firm’s return on equity.

Higher multiplier ratios tend to deliver higher returns on equity in keeping with DuPont analysis.

As an investor, if you look at a company and its multiplier, you would only be able to tell whether the company has been using high or low financial leverage ratios.

However, to know whether the company is at risk or not, you need to do something else as well.

You need to pull out other similar companies in the same industry and calculate equity multiplier.

If you see that the result is similar to the company you want to invest in, you would be able to understand that high or low financial leverage ratios are the norm of the industry.

That means if the company is financing its assets more by debt financing and the other companies in the industry have been doing the same, then this may be the norm.

But financing the assets through debt is still a very risky business. That’s why you need to go to the advanced computation and look at the financial leverage ratios in detail.

A practical example of equity multiplier

The balance sheet of the XYZ Company is as follows:

Balance sheet, US$ in thousands

Since the XYZ Company has preferred stock outstanding, we should compute common shareholders’ equity. Thus, the common shareholders’ equity at the beginning of the current year is $31,740,000 ($33,740,000 – $2,000,000) and $34,060,000 ($36,060,000 – $2,000,000) at the end of the current year.

Equity Multiplier 20X7 =$52,970,000 = 1.669
$31,740,000

 

Equity Multiplier 20X8 =$55,870,000 = 1.640
$34,060,000

The equity multiplier for the XYZ Company is 1.640. Compared with a baseline of 1.669, this indicates that the company’s performance is lacking in this area, and management has to take measures to improve this ratio.

 

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