Equity Multiplier

Equity multiplier (also called leverage ratio or financial leverage ratio) is the ratio of total assets of a company to its shareholders equity. A high equity multiplier means that the company's capital structure is more leveraged i.e. it has more debt.

Equity multiplier differs from other debt-management ratios in that it is calculated by comparing average values instead of closing values. If the difference between average and closing values is small, debt ratio can be converted to equity multiplier and vice versa using simple algebra.

Formula

Equity multiplier can be calculated using the following formula:

Equity Multiplier =Average Total Assets
Average Total Shareholders' Equity

Equity multiplier features in the DuPont analysis. It is called multiplier because it is the factor which relates return on assets (ROA) with return on equity (ROE) as follows:

Return on Equity (ROE) = Returns on Assets (ROA) × Equity Multiplier

DuPont return on equity analysis breaks up ROE into net profit margin, asset turnover and financial leverage (represented by equity multiplier as shown below:

ROE = Profit Margin × Total Asset Turnover × Equity Multiplier

A high equity multiplier leads to a higher return on equity but at the cost of increased risk.

Examples

Example 1: Calculating equity multiplier

Company EP has average total assets of $100 billion, beginning equity of $40 billion, net income for the year of $10 billion and dividends paid during the year of $4 billion.

We calculate the equity multiplier as average total assets divided by average total equity.

Average total assets are $100 billion

Closing total equity = beginning equity + net income − dividends = $40 b plus $10 b minus $4 b = $46 billion

Average total equity = ($40 billion + $46 billion) ÷ 2 = $43 billion

Equity multiplier is hence $100 billion divided by $43 billion and it equals 2.33

Example 2: Converting debt-to-equity ratio to equity multiplier

Company DP has debt to equity ratio of 2. Find the equity multiplier

Debt/Equity = 2

Since Debt = Assets − Equity

(Assets − Equity)/Equity = 2

Assets − Equity = 2 × Equity

Assets = 2 × Equity + Equity = 3 × Equity

Assets/Equity = 3

Hence, equity multiplier is 3.

Written by Obaidullah Jan, ACA, CFA and last modified on