Table of Contents
- 1 What is Equity Multiplier (EM)?
- 2 Formula
- 3 Calculation (Example)
- 4 Interpretation and Analysis
- 5 Relation with DuPont & Impact on ROE:
- 6 Advantages and Disadvantages of Equity Multiplier
- 7 Problems with Equity Multiplier Metric
What is Equity Multiplier (EM)?
Equity Multiplier is a key financial metric that measures the level of debt financing in a business. In other words, it is defined as a ratio of ‘Total Assets’ to ‘Shareholder’s Equity’. If the ratio is 5, equity multiplier means investment in total assets is 5 times the investment by equity shareholders. Conversely, it means 1 part is equity and 4 parts are debt in overall asset financing.
The formula of equity multiplier is as follows:
Equity Multiplier = Total Assets / Common Shareholder’s Equity
Total Assets: Total assets would mean all the assets of the company or one can take the total asset side of a company’s balance sheet. This was the understanding from the asset side. From the liability side, a total of all the liabilities and equity capital are covered for arriving at the figure of total assets.
Common Shareholder’s Equity: It means only the common shareholder’s funds. You should note that preference shares would not form part of this. The reason behind not including the preference share is its nature of a fixed obligation.
Let us understand the calculation using the following example:
Total Assets of a Company = $100 Million
Common Shareholder’s Equity = $ 20 Millions
Preferred Share = $ 10 Millions
Using the equity multiplier equation as follows
Equity Multiplier = Total Assets / Common Shareholder’s Equity = 100 / 20 = 5.
We get the multiplier of 5. This simply means that total assets are 5 times the total shareholder’s equity.
Interpretation and Analysis
Running a business needs investment in assets. You do it in two ways i.e. debt or equity. A ratio of 5 times states that total assets are 5 times that of its equity. In other words, 1 out of 5 parts of assets are financed by equity and remaining i.e. 4 parts are financed by debt. In percentage terms, 20% (1/5) is equity-financed and 80% (4/5) is debt-financed.
Our mind is always inquisitive about categorizing everything between good and bad. So, before jumping on to whether the multiple of 5 is good or bad, let us understand that the comparison is possible with 2 things – ‘Industry Standards’ and ‘Own Past Multiple’.
If the multiple is higher than its peers of the industry, you can safely say that the company has higher leverage.
Own Past Multiples
Comparing our multiple with own past multiples can help us gain only the trend of it. If the trend is rising, it can be an alarming situation for finance managers because, with rise in debt proportion, further debt borrowing becomes difficult. If the rise is not accompanied by sufficient profitability and efficient use of assets, it can lead the company towards financial distress.
Relation with DuPont & Impact on ROE:
The DuPont Analysis attempts to break down ROE into 3 components viz. Operating Profit Margin Ratio, Asset Turnover Ration and Equity Multiplier. The product of all 3 components will arrive at the ROE. DuPont formula clearly states a direct relation of ROE with Equity Multiplier. Higher the EM, higher is the ROE and vice-versa.
Why there is a directly proportional relation between ROE and EM? Since the higher debt in the overall capital reduces the cost of capital with the basic assumption that ‘debt is a cheaper source of capital’. The assumption is safely defended by taxes i.e. the interest on the debt is a tax-deductible expense. If the rate of interest is 10% and taxes is 40%. The effective cost of debt is calculated as 10% (1- 40%) [Interest * (1-Tax Rate)].
Advantages and Disadvantages of Equity Multiplier
Both higher and lower EM can have its share of benefits and disadvantages.
High debt proportion in capital structure may have the following issues
- Higher debt means a higher risk of insolvency. If the profits decline under any circumstances, the chances of not meeting the financial and other obligations increase.
- The ability to borrow more debt becomes tough since it already leveraged high.
On the other hand, lower EM can signify inefficiency in creating value for shareholders by way of tax benefits due to leverage.
There can’t be one ideal equity multiplier. It should be part of the overall strategy of the business. This may depend a lot on industry and other factors such as availability of debt, size of the project, etc.
Problems with Equity Multiplier Metric
There are certain issues that can dilute the use of equity multiplier for analysis. Cautionary measures are advisable.
Total assets show a smaller figure due to this and hence the metric is skewed.
Negative Working Capital
Since the definition of debt here includes all liabilities including payables. So, in the scenario of negative working capital, there are assets that are financed by a capital having no cost. Here, the general interpretations fail.
Highly profitable businesses may not share heavy dividends with shareholders and use the profit as a source of finance for most assets. The metric has hardly any meaning.
Seasonal business tends to have most business in one quarter of a year say Q1. Equity multipliers for Q1 and the other 3 quarters will show different results for the metric.1–3