The equity multiplier is a financial leverage ratio, used to measure how many dollars from equity is used to finance the assets of a company. In other words, it states the percentage of assets that have been financed by shareholders.
The formula to calculate the equity multiplier is:
Equity Multiplier = Total Assets / Total Equity
The values against variables in the formula can easily found in financial statements of the company.
Alpha company was started five years ago and specialized in textile manufacturing; the management of the company is planning for first initial public offering (IPO) in next year. Currently, it has total assets of worth $1,000,000 and equity portion of $800,000 in its recent financial statements.
Total Assets = $1,000,000
Total Equity = $800,000
Equity Multiplier = $1,000,000 / $800,000 = 1.25
The equity multiplier 1.25 means that the alpha company is funding its assets through a minimum level of debt financing if the result of the ratio would higher than the financial leverage will be higher. Normally higher the equity multiplier indicates that the company is more dependent on debt financing than equity which will result in more risk due to debt servicing cost.
Equity Multiplier and DuPont Analysis
The equity multiplier is an important element of the DuPont analysis, which is used in the formula to measure financial leverage, affects the return on equity.
DuPont Analysis = [Net Income / Net Sale] * [Sales / Total Assets] * [Total Assets / Total Equity]
According to the analysis, the higher equity multiplier will result in increased return on equity.