It is calculated by dividing a company’s total assets by its total shareholders’ equity. As with all liquidity and financial leverage ratios, the equity multiplier shows how risky a company is to creditors. Businesses that depend significantly on debt financing pay high service costs and thus need to generate more cash flows to cover their operations as well as obligations. This ratio is therefore used by banks and lenders, and even investors to assess a company’s financial leverage. The equity multiplier formula is one kind of financial ratio that mainly determines how a company’s assets are funded, especially its shareholders.
Other leverage ratio equations are similar, using some formulaic combination of a company’s assets, liability and shareholder equity to measure the amount of debt being used to finance assets. The procedure for calculating the equity multiplier is included in the debt. This is calculated by restating the company’s total assets in the formula of equity multiplier formula as debt plus equity. While the equity multiplier formula measures the ratio of total assets to total shareholder’s equity, it also reflects a company’s debt holdings. As mentioned earlier, a company can only finance purchases of new assets using equity or debt.
Examples of Equity Multiplier Formula
It’s calculated by dividing a firm’s total assets with total equity. Keep in mind, that there is no exactly perfect equity multiplier ratio, a good equity multiplier depends on the industry and the company’s historical performance. Too high an equity multiplier ratio may indicate that the company had a high debt burden.
Calculating Equity Multiplier is straightforward, which helps to know the shareholders’ net equity finances and the number of assets of a firm. Suppose the Equity Multiplier ratio is 2, which means investment in total assets is 2 times by total equity of shareholders. Apple, an established and successful blue-chip company, https://goodmenproject.com/business-ethics-2/navigating-law-firm-bookkeeping-exploring-industry-specific-insights/ enjoys less leverage and can comfortably service its debts. Due to the nature of its business, Apple is more vulnerable to evolving industry standards than other telecommunications companies. On the other hand, Verizon’s multiplier risk is high, meaning that it is heavily dependent on debt financing and other liabilities.
Equity Multiplier (Overview: Definition, Formula, Ratio, Analysis)
It is arrived at by comparing its all total assets against its overall shareholder’s equity. This equity equation ratio also indicates how much debt or loan financing is employed to acquire company assets after deducting day-to-day performance. Like other financial leverage ratios, the equity multiplier can show the amount of risk that a company poses to creditors. In fact, creditors and investors interested in investing in a company use this ratio to determine how leveraged a company is. The company may also be unable to obtain further financing to expand its market reach.
The relative to high historical standards, industry averages, or a company’s peers results indicate a company utilizing a considerable debt to mainly finance company assets. Companies who are having a higher debt burden will have huge debt servicing type of costs. HP Inc’s balance sheet for 2020 states that total assets were $34,681, and its total shareholder equity was worth $2,228. Inputting these values into the EM equation provides HP with a leverage ratio of 15.56. Moreover, this multiplier can show the level of debt that was used by a company in order to acquire assets and maintain operations.
Calculating a using an Equity Multiplier Debt Ratio
Companies mainly finance their purchase of assets from debt or equity, or some have a combination of equity and debts both. To explain the EM formula further, we will use Apple Inc. and Verizon Communications Inc. Apple’s total assets stood at $305 billion, while the value of the shareholder’s equity stood at $130 billion in March of 2016. Take the total value of assets in a company and divide that value by the total value of shareholder equity. That said, the EM ratio is still capable of providing a quick look into a company’s asset financing structure.
If ROE changes over time or diverges from normal levels for the peer group, the DuPont analysis can indicate how much of this is attributable to the use of financial leverage. If the equity multiplier fluctuates, it can significantly affect ROE. An equity multiplier of two (2) means that half the company’s assets are financed with debt, while the other half is financed with equity. Imaging that a company has a total asset of $1,000,000 on its balance sheet and $200,000 in shareholder’s equity. Let’s calculate a company’s equity multiplier by using a fictional example to get a better sense of the financial concept. On the other hand, if a company’s EM is low, it means that the company does not have as many assets financed through debt.
Total assets refer to a company’s total liabilities plus its stockholder equity. Stockholder equity represents the amount of money invested in the business by the owners and any retained earnings. It can also be represented by a company’s assets less its liabilities. When a firm is primarily funded using debt, it is considered highly leveraged, and therefore investors and creditors may be reluctant to advance further financing to the company.
A high equity multiplier indicates a high level of risk because it shows that the company has been funding its asset growth through debt. Many interpret that an equity multiplier is also known as one of the financial leverage ratios. Or a leverage ratio, and it is one of the ratios which is used in the Analysis of financial law firm bookkeeping health. This ratio tells us that Tesla’s assets are worth 2.34 times as much as the total stockholder equity. Tesla is financing 42.6% of its assets through stockholder equity and 57.4% with debt. Verizon seems to have a majority of its assets financed through debt which can signify high debt service charges.