In general, investors look for companies with a low equity multiplier because it indicates that the company is financing asset purchases with more equity and less debt. Companies with a high debt load may be financially risky. This is especially true if the company begins to struggle to generate the cash flow from operating activities (CFO) required to repay the debt and the associated servicing costs, such as interest and fees. So read on to learn about how to calculate the equity multiplier and the formula.<\/p>\n\n\n\n
The Equity Multiplier is a key financial metric that measures a company’s level of debt financing. In other words, it is the ratio of ‘Total Assets’ to ‘Shareholder’s Equity. If the equity multiplier is 5, it means that the investment in total assets is 5 times the investment by equity shareholders. In contrast, it means that in total asset financing, 1 part is equity and 4 parts are debt.<\/p>\n\n\n\n
The equity multiplier formula is as follows:<\/p>\n\n\n\n
Total Assets \/ Common Shareholder’s Equity = Equity Multiplier<\/strong><\/p>\n\n\n\n In this case,<\/p>\n\n\n\n Let’s look at an example to better understand how to calculate the equity multiplier:<\/p>\n\n\n\n Assume,<\/p>\n\n\n\n The equity multiplier formula is as follows:<\/p>\n\n\n\n Total Assets \/ Common Shareholder’s Equity = 100 \/ 20 = 5.<\/strong><\/p>\n\n\n\n We get a multiplier of five. Simply put, total assets are five times total shareholder equity.<\/p>\n\n\n\n Running a business necessitates the purchase of assets. So you can do it in two ways: with debt or with equity. A 5 times ratio indicates that total assets are 5 times that of equity. In other words, one-fifth of assets are funded by equity, while the remaining four-fifths are financed by debt. In percentage terms, 20% (1\/5) is equity-financed, while 80% (4\/5) is debt-financed.<\/p>\n\n\n\n Also, our minds are constantly inquisitive about categorizing anything as good or bad. But, before we get into whether the multiple of 5 is good or poor, it is important to understand that the comparison is possible with two items \u2013 \u2018Industry Standards’ and \u2018Own Past Multiple’.<\/p>\n\n\n\n If the multiple is greater than that of the company’s rivals in the market, it is fair to assume that the company has greater leverage.<\/p>\n\n\n\n Comparing our multiple to our previous multiples will only provide us with a pattern. If the trend continues, it can be a worrying situation for finance managers because as debt proportions rise, further debt borrowing becomes more difficult. So if adequate profitability does not follow the increase and efficient asset utilization, the business will face financial distress.<\/p>\n\n\n\n We can also use the debt ratio and equity multiplier to calculate a company’s debt amount. Companies fund their investments with debt and equity, which serve as the basis for both formulas. Total Capital is equal to the amount of total debt and total equity.<\/p>\n\n\n\n The debt ratio is the percentage of a company’s assets that are funded by debt. We can measure it in the following manner using the equity multiplier formula:<\/p>\n\n\n\n Total Debt \/ Total Assets = Debt Ratio<\/strong><\/p>\n\n\n\n Using ABC Company as an example, we can calculate the debt ratio as follows:<\/p>\n\n\n\n Debt Ratio = 200,000\/1,000,000 = 0.2, or 20%<\/strong><\/p>\n\n\n\n We may also use the equity multiplier to calculate a company’s debt level using the following formula:<\/p>\n\n\n\n Debt to Equity Ratio = 1 \u2013 (1\/Equity Multiplier)<\/strong><\/p>\n\n\n\n Debt Ratio = 1 \u2013 (1\/1.25) = 1 \u2013 (0.8) = 0.2, or 20%<\/strong><\/p>\n\n\n\n DuPont Analysis is a financial evaluation tool developed by DuPont Corporation for internal examination purposes. It was developed in the 1920s by the management at DuPont Corporation for a quantitative assessment of the company’s profitability. The DuPont model divides return on equity (ROE) into three components: net profit margin, asset turnover, and equity multiplier. So ROE is a measure of a company’s net income earned for its shareholders. As the value of the ROE increases over time, DuPont analysis determines how much of the adjustment is due to financial leverage. Also, any changes in the equity multiplier’s value result in changes in the value of ROE. The ROE formula looks like this:<\/p>\n\n\n\n ROE = Net Profit Margin x Turnover of Total Assets x Financial Leverage Ratio<\/strong><\/p>\n\n\n\n or<\/p>\n\n\n\n ROE = [Net Income \/ Sales] x [Sales \/ Average Total Assets] x [Average Total Assets \/ Average Shareholder’s Equity] x [Average Total Assets \/ Average Shareholder’s Equity]<\/strong><\/p>\n\n\n\n There is a clear relationship between ROE and the equity multiplier in the formula above. Any rise in the value of the equity multiplier raises the ROE. A high equity multiplier indicates that the company gets more leverage in its capital structure while having a lower total cost of capital.<\/p>\n\n\n\n Both higher and lower EM may have advantages and disadvantages.<\/p>\n\n\n\n The following issues can arise as a result of a high debt proportion in the capital structure:<\/p>\n\n\n\n Lower EM, on the other hand, can indicate inefficiency in creating value for shareholders through tax benefits due to leverage.<\/p>\n\n\n\n There can’t be a perfect equity multiplier. It should be a part of the company’s overall plan. This can vary greatly depending on the industry and other factors such as debt availability, project size, and so on.<\/p>\n\n\n\n Certain issues can taint the use of the equity multiplier for research. Hence, one should take precautionary steps.<\/p>\n\n\n\n As a result, total assets display a lower number, and the metric is distorted.<\/p>\n\n\n\n Since the concept of debt in this context encompasses all liabilities, including payables. As a result, in the case of negative working capital, there are assets that are funded by capital<\/a> that has no expense. The general interpretations fail here.<\/p>\n\n\n\n Highly profitable businesses may not pay out large dividends to shareholders and may use profits to finance the majority of their assets. So the metric has no value.<\/p>\n\n\n\n Seasonal businesses usually do the majority of their business in one quarter of the year, say Q1. Therefore, equity multipliers for the first and third quarters would produce different results for the metric.<\/p>\n\n\n\n Assume ABC has $10 million in net assets and $2 million in stockholders’ equity. It has a 5 equity multiplier ($10 million $2 million). This suggests the company ABC uses equity to fund 20% of its assets and debt to finance the remaining 80%.<\/p>\n\n\n\n Business DEF, which is in the same industry as company ABC, on the other hand, has total assets of $20 million and stockholders’ equity of $10 million. It has a 2 equity multiplier ($20 million x $10 million). This suggests that the company DEF uses equity to fund half of its assets and debt to fund the other half.<\/p>\n\n\n\nHow to Calculate Equity Multiplier<\/span><\/h2>\n\n\n\n
Analysis and Interpretation<\/span><\/h3>\n\n\n\n
Industry Requirement<\/span><\/h4>\n\n\n\n
Possess Past Multiples<\/span><\/h4>\n\n\n\n
Using the Equity Multiplier to Calculate the Debt Ratio<\/span><\/h3>\n\n\n\n
Analysis of DuPont<\/span><\/h3>\n\n\n\n
The Relation Between ROE and EM<\/span><\/h3>\n\n\n\n
Equity Multiplier Benefits and Drawbacks<\/span><\/h3>\n\n\n\n
Greater EM<\/span><\/h4>\n\n\n\n
Reduced EM<\/span><\/h4>\n\n\n\n
The Ideal EM<\/span><\/h4>\n\n\n\n
Issues with the Equity Multiplier Metric<\/span><\/h3>\n\n\n\n
Depreciation is increased<\/span><\/h4>\n\n\n\n
Working Capital Deficit<\/a><\/span><\/h4>\n\n\n\n
Profitable Finance<\/span><\/h4>\n\n\n\n
Seasonal Enterprise<\/span><\/h4>\n\n\n\n
An Example of a Multiplier of Equity<\/span><\/h3>\n\n\n\n