You may be wondering what equity multiplier means. Well, it’s a leverage ratio that basically measures the part of the company’s assets financed by equity. So, it shows the percentage of the assets that are owned or financed by shareholders.
Moreover, this multiplier can show the level of debt that was used by a company in order to acquire assets and maintain operations. If the multiplier is low, it shows that the company is not able to obtain debt from lenders, or that the use of debt is avoided by management. If the multiplier is high, it shows that a big portion of the company’s assets is financed by debt.
Would you like to find out more about the equity multiplier and the way it works? Then you’ve come to the right place.
Analyzing
So, an equity multiplier is used to analyze the debt and equity financing strategy of a company. If the ratio is high, it indicates that more assets were not funded by equity, but rather by debt.
If a company’s assets are mainly funded by debt, then it’s considered to be leveraged and has more risks for creditors and investors. Additionally, it indicates that the current investors don’t own as much as the current creditors when it comes to the assets.
Usually, you would prefer a lower multiplier ratio than a higher one. The reason is the fact that it is more favorable, being less dependent on debt financing and no high debt servicing costs. So, you’d be happier with a lower one, as a higher one is risky and has disadvantages.
The Equity Multiplier Formula
The multiplier can be calculated by using a formula. So, if you weren’t too fond of math when you were in school, get ready for it because you’ll need it.
The formula is calculated like this:
The values for the total assets and total shareholder’s equity can be found on the balance sheet, so check that before calculating. Also, it can be calculated by anyone who has access to the firm’s yearly financial reports.
Equity Multiplier Example
So, let’s say that you own a company that is responsible for the Internet. Basically, your company supplies and installs cables in homes and company buildings. Then, you decide that you want the company to be public in the next years. For that, you need to calculate the equity multiplier ratio, so you rush to get the balance sheet.
Imagine that your total asset value is of $1,000,000, and the total equity is $900,000. You use the formula, and the ratio results in 1.11. That is very low, and it means that you have low levels of debt. While investors finance 90% of your assets, only 10% are financed by debt. This means that you have a very conservative firm and that returning on equity will be negatively affected by your ratio.
To conclude, an equity multiplier is used to calculate a firm’s percentage of assets financed or owned by shareholders. It shows the level of debt used to acquire assets. By now, you probably find it easier to calculate it and know what a low or high ratio means.