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What is Equity Multiplier
The ‘Equity Multiplier’ is used to evaluate the financial strength of a company by obtaining a ratio of its total assets to the ratio of the total value of its shareholders.
An equity multiplier is important in determining the percentage of potential risk that a company is going through and its overall leverage status.
Equity Multiplier Formulae
There are basically two usable formulae of calculating the equity multiplier. One is the simple mathematical division of the company assets by the stockholder’s equity.
The second way is a reciprocal method where the equity ratio of the company is divided by a value of one in the numerator while the ratio itself is in the denominator.
This equity ratio however needs to be obtained first before the application of this method otherwise it will not work. Both of these calculation manners are distinct and each includes the usage of a particular formula.
Equity multiplier = Total assets of company / Stockholders’ equity
This is a straightforward way of obtaining the ratio by simple division of the company’s total assets by the stockholders’ equity. The stockholders’ equity can be obtained by the following equation:
Stockholders’ equity = Company’s total assets - Company’s liabilities
If the stockholders’ equity has even the slightest of error in its calculation of significant figures and decimal points then the multiplier’s exact value will differ.
Equity multiplier = 1 / Equity Ratio
This is a slightly advance way yet the easiest way to obtain the desired ratio. This method depends on the fact that a company’s total assets are always equal to the addition of debt with equity which in other words concludes an equation of:
Company’s total assets = debt + equity
This method uses equity ratio as the reciprocal (in the denominator of the fraction) and is divided by the value of one.
However for this method to be accurate, the equity ratio itself needs to be obtained first which is quite easily achieved by the following equation:
Equity ratio = 1 – debt ratio
This multiplier has an essential role to play in the DuPont Analysis. This analysis splits the ‘Return on Equity’ (ROE) into three parts.
The return on equity is basically the estimation of the efficiency of a company’s usage of investments to promote its earnings growth. The returns on equity divisions are simply financial ratios that include net profit margin, asset turnover and the financial leverage.
These three ratios are combined to calculate the return on equity value. The ROE has a crucial performance in figuring out which of these is underperforming in the business.
Formula of return on equity
Return on equity = net profit margin x asset turnover x financial leverage (equity multiplier)
If the multiplier ratio is not as expected or is going through a pattern of ebb and flow then the ROE value can be severely affected. Conclusively, the equity multiplier can be calculated by two different ways. Each method uses a unique formula
Equity Multiplier Ratio
This ratio is used to depict the financial strength of a company by showing which part of equity multiplier ratio is dominated.
Since the equity multiplier ratio of a company is obtained by dividing its total assets by the equity of its shareholders, the part of the ratio which is influenced the most shows how overwhelming is the role of that particular part in the company’s overall financial state.
Hence, an equity multiplier ratio of a lower value is considered to be better in terms of financial state in comparison with an equity multiplier ratio of a higher value.
This is because each part of this ratio is showing the command of it over the other and depending on the ratio’s value, a percentage of the company’s financing of its total assets by equity and the financing of its total assets by debt is obtained.
Therefore a ratio of a lower value would indicate that more of the assets are being funded by equity rather than debt and that the company’s financial status is fair enough to be called in an equilibrium.
A simple example used to explain the influence of the equity multiplier ratio on the financial state of a company is by using a scenario of any two companies, Company A and Company B. However, both of these companies must have different equity multiplier ratios.
Suppose the Company A’s total assets are $100 billion and the equity of its stockholders is $20 billion. By dividing the total assets by the stockholders’ equity, we get the equity multiplier’s value to be 5.
This represents that Company A is financing 20% of its assets by equity and rest of it by debt. This company therefore is in a larger risk due to its high dependency rate on debt rather than equity.
Similarly, suppose the Company B’s total assets are also $100 billion but the equity of its stockholders if $50 billion.
Once again, upon obtaining the equity multiplier ratio we will notice that we have obtained a certain value, which is, of 2. In this case, Company B is financing 50% of its assets by equity and rest by of it by debt.
In contrast, comparing Company A and Company B’s leverage status and debt dependency, we will notice that Company’s B financial strength is evidently and considerably much more than that of Company A since it is only financing its assets by 50% of the debt. On the contrary, Company A is financing 80% of its assets by debt and thus poses a high risk.
Conclusively, if a business or company is profitable enough it would certainly not be dependent on debts since it has enough incoming funds to look after its assets. Thus, in case of a high equity multiplier ratio, a company is more likely to be capitalizing its liabilities with the help of debt rather than the profit obtained since the profit is not enough to fund its payables.