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What is an Equity Multiplier?
An equity multiplier is a formula used to calculate a company's financial leverage, which is the debt a company uses to finance its assets. It is known as a debt management ratio. It can be calculated by looking at a company's balance sheet and dividing the total assets by the total stockholder equity. The resulting number is a direct measurement of the total number of assets per dollar of the stockholders' equity. A lower calculated number indicates lower financial leverage and vice versa. Generally, a lower equity multiplier is desired because it means a company is using less debt to fund its assets.
The equity multiplier is also a kind of leverage ratio, which is any method of determining a company's financial leverage. Other leverage ratio equations include the debt-to-equity ratio, which assesses financial leverage by taking a company's total liability and dividing it by the shareholders' equity. 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 equity multiplier can be used by investors as a part of a comprehensive investment analysis system, such as the DuPont Model. The DuPont Model uses this formula alongside other measurements, such as asset turnover and net profit margin, to analyze a company's financial health. These multi-faceted approaches are useful to investors, helping them to inspect a company from every pertinent angle. With a system such as the DuPont Model, an investor might look at a company's net profit margin and determine it's a good investment. If they had looked also at the equity multiplier, however, they might have seen that such profits were fueled largely by debt, and that the company may actually make for an unstable investment.
A high equity multiplier isn't a guarantee that a company is a bad investment or that it's destined for financial ruin; it only indicates that such scenarios are more likely with a company that has a high amount of financial leverage. Some companies may wisely use financial leverage to finance assets that will pull the company out of debt in the long run. As with any individual or company, the greater the debt used to finance assets, the greater the risk; this isn't the same as saying that a business carrying a greater amount of debt will fail, only that it's more likely to than company's carrying less debt.
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Discussion Comments
Using the equity multiplier, show how the amount of bank capital effects return to the equity holders,
Can financial leverage ratio be negative if equity is in deficit? If so, what are the implications?
@turquoise-- I think so, the equity multiplier, financial leverage and the DuPont model would belong to that category.
Due-diligence in investment basically means looking in-depth in an investment and doing lots of research on it before making any decisions.
As far as I know, there has always been research and investigations into potential investment. Bankers used to carry out a lot of these investigations. With time though, companies started realizing that they could make deals with the banks for fake in-thorough investigations that would hide the company's poor financial leverage.
There were several court trials as a result of this and the banks and companies that engaged in it were sued. Since then, there has been much more emphasis placed on investigating companies and their finances. That's why the equity multiplier, the DuPont model and similar methods have become important.
I read about something called "due-diligence in investment" in an article I read recently.
Are the equity multiplier and other analysis methods part of what is called "due-diligence"?
Yes, I imagine that a company with a high leverage doesn't look as promising as a company with low leverage.
But I think that one good thing about financial leverage is that the debt management ratio always stays the same. If a company has a certain percentage of debt, that number doesn't change if the company's value increases. So if the company has a good place in the market and keeps growing, it will be able to handle that debt very easily.
It could also work the other way around though, like if the value of the company actually falls. Then, it will be more difficult to handle the debt.
Like all things in business and economy, investing in company is also a risk. No matter what the equity multiplier tells us, I don't think we can ever know for sure if a business is going to be successful or not.
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