Equity Multiplier Definition
Equity multiplier is the financial leverage ratio. It used to measure the number of shareholders, which shareholders invest in the assets of the firm or company. It can be calculated by comparing total assets by total shareholder’s equity.
In other words, this ratio is used to shows the percentage of assets in the company which is financed by the shareholders. Equity multiplier (EM ) used to find the debt financing level of the company which used to maintain the operation of the company and acquire assets.
Equity multiplier ratio is used to indicate the company risk to the creditor. The company which rely on heavy debt financing will have a high debt service cost. For the payment for their operation and obligation, such type of companies needs to raise more cash flow.
To find how leveraged a company is creditors and investors use this ratio.
Equity multiplier formula can be calculated by dividing the total assets by total stockholder’s equity.
Equity Multiplier = Total Assets/ Total stockholder’s equity
From the balance sheet, we get the value to calculate the Equity multiplier.
Debt and equity financing strategy of any company can be analyzed by equity multiplier ratio. If the ratio is high then debt funding the asset greater as compared to equity. It means that high ratio company’s asset funded by the creditor is greater as compared to investors.
The company may be risky or high leveraged for the investors and creditor at that time when it is primarily funded by debt. It means that the current asset of the company greatly owns by the current creditor as compared to the current investors.
As compare to high equity multiplier ratio lower ratio is better. Because due to lower ratio company less dependent on the debt financing and do not have the high debt servicing cost.
In the DuPont analysis, this ratio is used to illustrate how leveraged a firm on its return on equity. According to DuPont analysis higher multiplier ratio delivered the high return on equity.
Lee has a telephone company which works with other company to maintain lines and other cables. In the next 2 years, Lee wants to bring this company to the public. For this, he makes sure to make the equity multiplier ratio favourable. In the financial statement, the total assets of Lee are $1,000,000 and total equity is $900,000. So the equity multiplier calculated as
Equity multiplier = total asset/ total equity
Equity multiplier for lee’s company is 1.11 which is a very low ratio. So the debt level of his company is very low because of 10 % of assets of his company financed by debt. 90 % assets of his company financed by the investor which is a good sign for his company.
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