Meaning and definition of Equity Multiplier
In finance, equity multiplier is defined as a measure of financial leverage. Akin to all debt management ratios, the equity multiplier is a method of evaluating a company’s ability to use its debt for financing its assets. The equity multiplier is also referred to as the leverage ratio or the financial leverage ratio.
As explained by Investopedia, the equity multiplier shows a company’s total assets per dollar of stockholders’ equity. The higher the equity multiplier, the higher is the financial leverage, which indicates that the company relies more on debt to finance its assets.
Calculating Equity Multiplier
The equity multiplier is calculated by dividing total assets by the common stockholder’s equity.
Formula for Equity Multiplier
The common formula used for calculating equity multiplier is:
Equity Multiplier = Total Assets / Stockholder's Equity
In addition to this formula, an alternative formula is also used for calculating equity multiplier is:
1 / Equity Ratio
This alternative formula is the reciprocal of the equity ratio. As mentioned previously, a company’s assets equal the sum of debt and equity. The equity ratio, therefore, calculates the equity portion of the assets of a company.
Using an Equity Multiplier
An equity multiplier is the reflector of the extent of leverage used by a company to finance its assets in addition to reflecting the value of a company’s assets as well as the value of its shareholders’ equity.
There are, however, certain instructions that can guide you with the usage of equity multiplier. These include:
- Evaluate the total assets and stockholders’ equity on the balance sheet.
- Divide the total assets by the stockholders’ equity to evaluate the equity multiplier.
- Calculate the equity multiplier for the direct competitors of the company besides the average equity multiplier for the industry in which the company operates on a financial website which provides stock quote info.
- Compare the company’s equity multiplier with that of its competitors. The company might be taking too much risk if the company’s equity multiplier is higher than the industry average. If, on the contrary, it is below the industry average, the company is probably using a conservative debt amount.
- Calculate the company’s equity multipliers in past years and compare them with the current equity multiplier of the company to identify any alterations.