Whether you are an investor, an owner, or an internal financial analyst, understanding how the equity multiplier works and how to interpret it is a helpful skill.
Defining the Equity Multiplier
The equity multiplier is a metric that tells the user what percentage of the company’s assets are loaned against shareholders’ equity. The smaller the calculated number for the equity multiplier, the less risky the financing is due to less debt owed by the company. It’s more favorable since there are lower debt servicing costs needed. When liabilities and/or assets change, the company’s equity multiplier changes.
Conversely, the bigger the equity multiplier, the more likely investors will be exposed to financial risk. This is due to the company having more outstanding debt, requiring more cash flows to service ongoing debt repayment, along with normal operations. A good rule of thumb is that anything lower than 2 is good, while anything higher than 2 signifies risk.
Putting It into Context
Since companies obtain financing through a mix of equity, debt, or both, it’s important to measure and monitor how the combination changes over time. Since investors look at the metric, among other financial yardsticks, it can influence how they determine if a company is worth investing in. Investors compare one company to others in the same industry and against historical measures to see how the company rates financially. The equity multiplier is measured relative to past measures, industry standards, or its sector competitors.
The ratio is calculated as follows:
Equity Multiplier = Total Assets / Total Shareholders’ Equity
Both input values are found on the company’s balance sheet, either on the quarterly or annual reports filed with the United States Securities and Exchange Commission.
If a company wants to go public, it can calculate this ratio to determine if its present results are robust for lenders’ review. Say a company has $2 million in total assets and $1.25 million in shareholders’ equity. Based on these numbers, it’s calculated as follows:
= $2,000,000 / $1,250,000 = 1.6
The equity multiplier in this scenario, which shows a moderate amount of borrowing, may or may not pose an issue for the company’s financial health.
If a business’ total assets are $450 billion, and shareholders’ equity, according to the financial statements, was $150 billion, the company’s ratio is 3X ($450 / $150).
If a different company’s assets are $825 billion with $165 billion of shareholders’ equity, the same resulting ratio is 5X ($825 / $165).
These calculations show that as the ratio of liabilities and asset values adjusts, the equity multiplier also changes because a company uses less debt and more shareholders’ equity to finance the assets. While higher equity multipliers can help companies grow faster, especially during low interest rate and high-growth environments, if borrowing costs rise and/or sales fall dramatically, it can forecast negative growth. Investors favor businesses with low equity multipliers since this indicates the company is using more equity and less debt to finance the purchase of assets.
Regardless of the company or the industry, understanding how the ratio is calculated and used in making investment decisions makes sense for both companies and their potential investors.
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