What is an equity multiplier?
An equity multiplier is a formula used to calculate a company's financial leverage, which is the debt a company uses to finance its assets. The equity multiplier is known as the debt management ratio. It can be calculated by looking at a company's balance sheet and dividing total assets by total equity. The resulting number is a direct measure of the total number of assets per dollar of equity. A lower calculated number indicates lower financial leverage and vice versa. In general, a lower equity multiplier is desired because it means a company is using less debt to fund its assets.
Equity multiplier is also a type of leverage ratio, which is any method for determining a company's financial leverage. Other leverage ratio equations include the leverage ratio, which measures financial leverage by taking a company's total liabilities and dividing it by equity. Other leverage ratio equations are similar, using a combination of formulas for a company's assets, liabilities, and equity to measure the amount of debt used to finance the assets.
Investors can use the stock multiplier as part of a comprehensive investment analysis system such as the DuPont model. DuPont's model uses the equity multiplier along with other measures, such as asset turnover and net profit margin, to analyze a company's financial health. These multifaceted approaches are useful for investors as they help them look at a company from all relevant angles. With a system like the DuPont model, an investor can analyze a company's net profit margin and determine that it is a good investment. However, if they had also looked at the stock multiplier, they might have seen that these gains were largely debt-driven and that the company could make a shaky investment.
A high equity multiplier does not guarantee that a company is a bad investment or destined for financial ruin; it just indicates that such scenarios are more likely with a company that has high financial leverage. Some companies may wisely use financial leverage to fund assets that will lift the company out of long-term debt. As with any individual or company, the more debt that is used to fund assets, the greater the risk; This is not the same as saying that a business with a greater amount of debt will fail, just that a company with less debt is more likely to fail.