Equity multiplier ratio, which is also known as financial leverage ratio, measures a proportion of the total assets of a company financed by its shareholders. It is usually used as an indicator of credit risk and as one of the key components of DuPont analysis.
The formula of equity multiplier ratio is expressed as follows:
If a company has preferred equity outstanding, the equity multiplier should be calculated in terms of common shareholders’ equity.
Total common shareholders’ equity is calculated as total equity less total preferred shareholders’ equity.
The balance sheet of the XYZ Company is as follows:
US$ in thousands
Since the XYZ Company has preferred stock outstanding, we should compute common shareholders’ equity. Thus, the common shareholders’ equity at the beginning of the current year is $31,740,000 ($33,740,000-$2,000,000) and $34,060,000 ($36,060,000-$2,000,000) at the end of the current year.
The equity multiplier for the XYZ Company is 1.640. Compared with a baseline of 1.669, this indicates that the company’s performance is lacking in this area, and management has to take measures to improve this ratio.
Equity multiplier analysis
Equity multiplier ratio is usually used to analyze the capital structure in terms of debt financing strategy. Higher values of ratio indicate that a company’s assets are financed to a greater extent by its creditors than by its shareholders. Lower values indicate that a company follows a conservative strategy in its assets financing strategy.
Equity multiplier magnifies profits generated by assets of the company, but it also magnifies its losses. Thus, this ratio also gauges the degree of risk associated with current debt financing strategy. The higher its value, the greater the risk and vice versa.
Let’s consider the example mentioned above and assume the industry average at the end of the current year is 1.813.
The value of 1.640 compared with the industry average of 1.813 indicates that management’s efforts are not sufficient to improve capital structure.
You can also calculate the equity multiplier ratio using our online calculator.