ABC Company is more leveraged than XYZ Company, and therefore has a higher level of risk. This is because a greater portion of ABC Company’s financing comes from debt, which must be repaid with interest. If ABC Company is unable to generate enough revenue to cover its interest payments, it may default on its debt obligations. For example, by borrowing funds a company can purchase assets and the after-tax income from the asset will exceed the borrowing cost. More reliance on debt financing results in higher credit risk – all else being equal.
Simply put, it’s the assets of the company divided by shareholders’ equity rather than debt. A company’s equity multiplier varies if the value of its assets changes, and/or if the level of liabilities changes. If assets increase while liabilities decrease, the equity multiplier becomes smaller. That’s because it uses less debt and more shareholders’ equity to finance its assets. Consider Apple’s (AAPL) balance sheet at the end of the 2021 fiscal year.
Calculation of Equity Multiplier
There’s a direct relationship between the Equity Multiplier and a firm’s debt liabilities. A lower Equity Multiplier indicates that a business is less dependent on borrowed funds, translating to lesser debt liability. Companies with higher Equity Multiplier are generally perceived to be riskier.
To have a better perspective of a company’s risk profile, the equity multiplier is generally considered in comparison to the company’s historical performance. To sum up, while both ratios provide insights into a company’s financial leverage, they do so from different perspectives and can therefore have different implications. It is essential to use these ratios wisely and understand their limitations. Therefore, a higher equity multiplier might coincide with a higher debt ratio, but this is not a strict rule.
Equity Multiplier Formula
Still, the company has also significantly improved its profitability (income/sales) and how much sales it generates from its assets (sales/assets) over the same period. In other words, Illinois Tool Works is excellently sweating its assets, even if those assets were supported by taking on more debt. In general, equity multipliers at or below how to calculate equity multiplier the industry average are considered better. If ROE changes over time or diverges from normal levels for the peer group, the DuPont analysis can indicate how much of this is attributable to the use of financial leverage. For our illustrative scenario, we will calculate the equity multiplier of a company with the following balance sheet data.
A higher ratio means a larger portion of a company’s assets is funded by debt, implying higher financial risk. A lower ratio suggests more assets are self-financed, which is usually more attractive to investors and creditors. A higher equity multiplier indicates a business with more of its assets financed by debt, suggesting greater financial risk. By contrast, a lower ratio suggests more of a company’s assets are paid for by shareholders, referring to potentially safer financial prospects.
The equity multiplier and DuPont analysis
When a firm is primarily funded using debt, it is considered highly leveraged, and therefore investors and creditors may be reluctant to advance further financing to the company. A higher asset to equity ratio shows that the current shareholders own fewer assets than the current creditors. Total assets mean all current assets (debtors, inventories, prepaid expenses, etc.) and non-current assets (building, machinery, plants, furniture, etc) of the company’s balance sheet. This is important to note that preference shares would not be part of this because of the nature of the fixed obligation. This ratio is useful for all investors as it helps them understand a company’s financial leverage. The equity multiplier is crucial in evaluating a company’s capital structure and financial risk.