What Is Equity Multiplier?

An Equity Multiplier is a measure of a company’s financial leverage computed by comparing Total Company’s Assets with Shareholders’ Equity. In other words, it’s the amount of company’s assets financed or owed by the shareholders.

A financial leverage is a direct influence of a company’s capital structure on its efficiency of using its equity. Financial leverage allows the company to achieve an above-average economic effect by partly financing business activities with borrowed capital. However, high leverage ratio is associated with higher risks, since a company has more debt costs. Therefore, this ratio is used to evaluate a company’s financial leverage.

How to Calculate Equity Multiplier?

The Equity Multiplier is calculated by dividing company’s Total Assets by Total Stockholders’ Equity.

Equity\space Multiplier = \frac{Total\space Assets}{Total\space Stockholders'\space Equity}

A higher Equity Multiplier means company’s assets are financed more by debt, than by equity. This means a company takes more risks relying on borrowed funds and becomes less attractive for investors. That also means shareholders own less company’s assets.

Consequently, a lower Equity Multiplier means more assets are funded by investors and less by creditors. Lower Equity Multiplier is usually more desirable due to the fact of not owing as much money and, as a result, carrying less risk.

For example, if the ratio is 3, it indicates that two parts are debt and one part is stockholders’ equity in total assets funding.

It’s important to remember that the Equity Multiplier of a company should only be compared to the industry standard or to other companies in the same sector. The best way to examine it is to compare it over time and look for a trend. By creating a trend, we can see if there are any negative or positive changes. Higher or lower financial leverage does not necessarily indicate financial strength or weakness of a company because of differences in business models of different companies.

Example of How to Calculate Equity Multiplier

Company A has:

  • Total Assets of $ 3,000,000
  • Total Stockholders’ Equity of $ 1,500,000

As in the previous case, the Equity Multiplier is calculated as:

Equity\space Multiplier = \frac{\$3,000,000}{\$1,500,000} = 2

Which means Total Assets are 2 times the Total Shareholders’ Equity, so half of a company’s assets is financed by debt and half by shareholders.

Company B has:

  • Total Assets of $ 2,000,000
  • Total Stockholders’ Equity of $ 500,000

The Equity Multiplier is then computed as:

Equity\space Multiplier = \frac{\$2,000,000}{\$500,000} = 4

Which basically means Total Assets are 4 times the Total Shareholders’ Equity, so 25% of a company’s assets is funded by stockholders and 75% by debt.

Company A has a lower Equity Multiplier than Company B, which means company B uses more debt to fund their business.

Therefore, Company A is more preferred than Company B, because Company A takes less risks funding their assets mostly by Shareholders’ Equity.  Nevertheless, as it was mentioned before, financial leverage enables gains and losses to be multiplied.

For example, by borrowing funds a company can purchase assets and the after-tax income from the asset will exceed the borrowing cost.

How to Use Equity Multiplier in DuPont Analysis?

DuPont Analysis is a financial model which is used to decompose the different constituent pieces of ROE (Return on Equity). It allows to indicate how financial leverage affects a company’s Return on Equity, determine sources of strengths and weaknesses and focus attention on drivers value.

Equity Multiplier, Asset Turnover and Net Profit Margin are used to calculate Return on Equity, which allows to indicate how each one of them affects ROE.

ROE = Profit\space Margin \times Asset\space Turnover \times Equity\space Multiplier ROE = \frac{Net\space Income}{Sales} \times \frac{Sales}{Total\space Assets} \times \frac{Total\space Assets}{Shareholders'\space Equity} ROE = \frac{Net\space Income}{Total\space Assets} \times \frac{Total\space Assets}{Shareholders'\space Equity} = ROA \times Equity/space Multiplier

Return on Equity can be calculated by multiplying Profit Margin by Asset Turnover by Equity Multiplier.

Profit Margin illustrates Operating Efficiency, Asset Turnover illustrates Asset Use Efficiency and Equity Multiplier illustrates Financial Leverage. Decomposing these pieces allows to evaluate how, for example, Net Income affects Return on Equity.