The Equity Multiplier, also known as the financial leverage ratio, is a financial tool that unveils the degree to which a company's assets are funded by stock versus debt. As a key indicator of risk, this tool allows investors to assess how much of a company's total assets are financed by equity rather than debt.
Defining the Equity Multiplier
The equity multiplier functions as a litmus test for discerning the proportion of a company's total assets that are funded by shareholders' equity in contrast to debt. Calculating this ratio involves dividing the total asset value of a company by the equity held in the company's stock. Consequently, an elevated equity multiplier denotes a high reliance on debt for financing assets, while a low equity multiplier implies a reduced dependence on debt.
This tool, synonymous with the leverage ratio or the financial leverage ratio, forms one of the three key components of the DuPont analysis. It is fundamental in understanding a company's financial health and strategy, especially in the context of its industry and peers.
The Implications of a High and Low Equity Multiplier
When a company possesses a high equity multiplier, it suggests that the firm is predominantly dependent on debt to finance its assets. Conversely, a lower equity multiplier may imply that the firm is primarily utilizing shareholders' equity to fund its assets or that it has struggled to secure lenders for a loan.
However, the interpretation of these ratios should be industry-specific. For instance, one company's high equity multiplier could reflect an aggressive growth strategy fueled by debt, while in another sector, the same ratio could signal financial vulnerability.
The Equity Multiplier in Action
Companies often finance the procurement of new and existing assets through the issuance of equity or debt, and sometimes a blend of both. Investors often utilize the equity multiplier to understand how much shareholders' equity is devoted to financing a company's assets.
This ratio can provide a snapshot of a company's financial structure. A lower Equity Multiplier, for instance, usually suggests a higher proportion of equity used to acquire assets. Yet, the lack of significant debt could indicate that the company struggled to secure the necessary credit rating to issue debt or obtain loans.
The Formula and Its Application
The equity multiplier is computed by dividing a company's total assets by the shareholder's equity. This metric serves as an alternative to the Debt Equity Ratio and can be used to compare companies within the same sector. Here, it may expose capital structures that deviate from the sector norm, prompting the investor or analyst to investigate the reason behind this anomaly.
However, the application of the equity multiplier across diverse sectors or industries is cautioned against. This is because different industries possess unique capital structures and debt/equity ratios that suit their specific needs. In such cases, the Enterprise Multiple or EV/EBITDA (Enterprise Value over Earnings Before Interest Tax Depreciation and Amortization) is a more suitable tool.
Summary
The Equity Multiplier is a number used to compare companies, arrived at by dividing total assets by owner’s equity, and it gives an idea of what proportion of the company’s assets have been financed through equity vs debt.
In general a low Equity Multiplier is a good sign because it means that a higher proportion of equity has been used to acquire assets, as opposed to funding assets with debt. However, the absence of significant debt could mean that the company lacked the credit rating to issue debt or take out loans.
It is computed by dividing the total Assets by the Shareholders Equity. The Multiplier is an alternative to the Debt / Equity Ratio, and can be used as a comparison tool between companies in the same sector, where it can reveal capital structures that are out of the norm for a sector and allow the investor or analyst the opportunity to consider why that is.
It should not be used across industries or disparate sectors, however, because different industries have different capital structures and debt/equity ratios that suit them; the Enterprise Multiple, another name for EV/EBITDA (Enterprise Value over Earnings Before Interest Tax Depreciation and Amortization), is a better tool for that.