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.
Equity multiplier can be calculated using the following formula:
|Equity Multiplier =||Average Total Assets|
|Average Total Shareholders' Equity|
Return on Equity (ROE) = Returns on Assets (ROA) × Equity Multiplier
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.
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.