A company acquires its assets either through debts or equity. Equity multiplier is also known as financial leverage ratio or leverage ratio. An equity multiplier uses the ratio between the company’s total assets to its stockholder’s equity to measure a company’s financial leverage.
An equity multiplier is used when comparing companies in the same industry or when using the industry’s standard as a point of reference.
Let us say Waterfront Company has $30 million worth of assets and the stakeholder’s equity of $6 million. That means that its equity multiplier is 5. That further means 20% of the company’s debts are financed through debt and that investors finance the remaining 80% of the assets.
Let us also assume; Milkwater Company operates in the same industry as Waterfront Company. Milkwater has assets of $50 million and $25 million as stakeholder’s equity. Its multiplier equity is therefore 2. That means that Milkwater uses equity to finance half of its assets, and the investors finance the remaining half.
Which is Better, Lower or Higher Equity Multiplier?
Waterfront Company has an equity multiplier of 5 while Milkwater has a multiplier of 2. Therefore, Waterfront has a higher equity multiplier. Waterfront is, therefore, financing most of its assets using debts.
When investors compare the two companies, they are likely to invest in Watermilk. Investors prefer companies with a lower equity multiplier.
Calculating the debt ratio
The debt ratio is the amount of a company’s assets that is funded through debt.
The formula is: Total Debts / Total Assets = Debt ratio
A high debt ratio arises when the debt accrued to a company is high considering its balance sheet. It is not possible for total debts to be negative and it cannot be greater than the total assets. The debt ratio is expressed as a percentage. It ranges between 0% and 100%.
Calculating the equity multiplier
An equity multiplier relates the balance sheet to the amount of equity. In this case, the balance sheet is also the sum of total assets.
The formula is: Total Assets / Total Equity = Equity Multiplier
Since the equity multiplier measures the leverage level of the company, the higher it is, the greater the extent of leverage.
Relationship between debt ratio and equity multiplier
To derive the equation, Debt ratio = 1 – (1/Equity multiplier), we will do the following steps.
Equity multiplier = Total assets / Total equity
The equation can also be written as:
Total equity / Total assets = (1 / Equity multiplier)
According to accounting fundamentals:
Total equity = Total assets – Total debt
If we substitute in the first equation,
(Total assets – Total debt) / Total assets = (1/ Equity multiplier)
When we simplify the equation we get;
1 – (Total debt / Total assets) = (1/ Equity multiplier)
When we rearrange the terms in the equation we get;
(Total debt / Total assets) = 1 – (1/ Equity multiplier)
Since total debt / Total assets is Debt ratio, then,
Debt ratio = 1 – (1/ Equity multiplier)
Instruction when using an Equity multiplier
To determine the level to which the company is leveraged, compare the present equity multiplier with multipliers from previous periods.
Remember to assess the stakeholder’s equity and total assets on the balance sheet
To gauge how the company is doing compared to its competitors, calculate the equity multiplier of its direct competitors. The information will reveal if the company is risking too much or it is within the industry’s limit.