An equity multiplier measures a company's financial leverage by using a ratio of the company's total assets to its stockholders' equity (also known as shareholders' equity). Generally, a lower equity multiplier indicates a company has lower financial leverage. It is better to have a low equity multiplier, because that means a company needs to use less debt to finance its assets.
The equity multiplier is calculated by dividing a company's total assets by its shareholders' equity. This ratio measures the total assets a company owns per dollar of its stockholders' equity. The equity multiplier of a company should only be used in comparison to the industry standard or to companies in the same sector.
For example, suppose company ABC has total assets of $10 million and stockholders' equity of $2 million. Its equity multiplier is 5 ($10 million ÷ $2 million), which means that 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 industry as company ABC, has total assets of $20 million and stockholders' equity of $10 million. Its equity multiplier is 2 ($20 million ÷ $10 million), which means that 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 that the company is taking on less debt to buy assets. In this case, company DEF is preferred to company ABC because, by not owing as much money, it carries less risk.