In general, investors look for companies with a low equity multiplier because this indicates the company is using more equity and less debt to finance the purchase of assets. Companies that have a high debt burden could be financially risky. This is particularly true if the company begins to experience difficulty in generating the cash flow from operating activities (CFO) needed to repay the debt and the associated servicing costs, such as interest and fees.
However, this generalization does not hold true for all companies. There can be times when a high equity multiplier reflects a company's strategy that makes it more profitable and allows it to purchase assets at a lower cost.
- An equity multiplier is a financial ratio that measures how much of a company's assets are financed through stockholders' equity.
- A low equity multiplier indicates a company is using more equity and less debt to finance the purchase of assets.
- Companies with a low equity multiplier are generally considered to be less risky investments because they have a lower debt burden.
- In some cases, however, a high equity multiplier reflects a company's effective business strategy that allows it to purchase assets at a lower cost.
Calculating a Company's Equity Multiplier
The equity multiplier is a ratio that measures a company's financial leverage, which is the amount of money the company has borrowed to finance the purchase of assets. This is the formula for calculating a company's equity multiplier:
Equity multiplier = Total assets / Total stockholder's equity
The equity multiplier is calculated by dividing the company's total assets by its total stockholders' equity (also known as shareholders' equity).
A lower equity multiplier indicates a company has lower financial leverage. In general, it is better to have a low equity multiplier because that means a company is not incurring excessive debt to finance its assets. Instead, the company issues stock to finance the purchase of assets it needs to operate its business and improve its cash flows.
When evaluating multiple companies as potential investments, investors can use the equity multiplier to compare companies in the same sector or to compare a specific company against the industry standard.
Example of an Equity Multiplier
Suppose company ABC has total assets of $10 million and stockholders' equity of $2 million. Its equity multiplier is 5 ($10 million ÷ $2 million). This means company ABC uses equity to finance 20% of its assets and the remaining 80% is financed by debt.
On the other hand, company DEF, which is in the same sector as company ABC, has total assets of $20 million and stockholders' equity of $10 million. Its equity multiplier is 2 ($20 million ÷ $10 million). This means company DEF uses equity to finance 50% of its assets and the remaining half is financed by debt.
Company ABC has a higher equity multiplier than company DEF, indicating that ABC is using more debt to finance its asset purchases. A lower equity multiplier is preferred because it indicates the company is taking on less debt to buy assets. In this case, company DEF is preferred to company ABC because it does not owe as much money and therefore carries less risk.
For some companies, a high equity multiplier does not always equate to higher investment risk. A high use of debt can be part of an effective business strategy that allows the company to purchase assets at a lower cost. This is the case if the company finds it is cheaper to incur debt as a financing method compared to issuing stock.
If the company has effectively used its assets and is showing a profit that is high enough to service its debt, then incurring debt can be a positive strategy. However, this strategy exposes the company to the risk of an unexpected drop in profits, which could then make it difficult for the company to repay its debt.
Additionally, a low equity multiplier is not always a positive indicator for a company. In some cases, it could mean the company is unable to find lenders willing to loan it money. A low equity multiplier could also indicate that a company's growth prospects are low because its financial leverage is low.