Equity multiplier can also compare the financial structure of different companies. A company with a higher equity multiplier is usually considered to be more leveraged than a company with a lower equity multiplier. However, suppose the equity multiplier had risen while sales/assets and income/sales were static or declining. In that case, it’s possible ROE could have increased because the company was taking on debt. Still, the company has also significantly improved its profitability (income/sales) and how much sales it generates from its assets (sales/assets) over the same period.

Using the Equity Multiplier to Calculate the Debt Ratio

Equity multiplier is a financial ratio that measures the extent to which a company is financed by debt or equity. This means it has borrowed a great deal of money to finance its operations. Low equity multiplier, on the other hand, indicates that a company is less leveraged and has more equity financing. The equity multiplier is also an important factor in DuPont factor analysis, which is a method of financial assessment devised by the DuPont Corp. for the purpose of internal review. The DuPont model breaks return on equity (ROE) into its constituent pieces, which are popular financial ratios and metrics.

Return on Equity (ROE) vs. Return on Assets (ROA)

It may, however, indicate that a company is unable to obtain debt financing on reasonable terms, which is a serious problem. You can use the “equity multiplier formula” or “equity multiplier ratio” to calculate a company’s debt ratio. These real-world examples from Apple and Verizon illustrate how companies can have different financial strategies reflected in their equity multipliers. Whether you’re risk-averse or looking for a potentially high return, understanding a company’s equity multiplier can give you an edge in making more informed investment decisions. As we mentioned above, equity multiplier only provides a snapshot of a company’s financial leverage at a single point in time. To get a more complete picture of a company’s leverage, you would need to calculate equity multiplier over multiple periods of time.

Everything You Need To Master Valuation Modeling

• This is not a problem while the interest rate environment is benign, but it’s a risky strategy when conditions change.
• Interpreting this mathematically, the higher the shareholder equity-financed portion of a company’s assets, the lower the equity multiplier ratio.
• ABC Company is more leveraged than XYZ Company, and therefore has a higher level of risk.
• The equity multiplier is a useful tool for investors to monitor risk and understand how a company generates returns for investors.
• As we mentioned above, equity multiplier only provides a snapshot of a company’s financial leverage at a single point in time.

Let us say Waterfront Company has $30 million worth of assets and the stakeholder’s equity of $6 million. That further means 20% of the company’s debts are financed https://www.bookstime.com/articles/direct-write-off-method through debt and that investors finance the remaining 80% of the assets. In general, a lower EM indicates that a company uses less debt to finance its assets.

This ratio provides a glimpse into the company’s financial leverage. A figure like 1.5 suggests moderate risk and leverage, often indicating a balanced approach to asset financing. The equity multiplier, like all liquidity and financial leverage ratios, indicates the company’s risk to creditors. Companies that rely too heavily on debt financing will face high debt service costs and will need to generate more cash flows to cover their operations and obligations.

Apple’s ratio of 2.346 indicates that the company incurs less debt servicing fees while enjoying less leverage. On the other hand, Verizon has a ratio of 12.895, showing the company is heavily reliant on debt financing and other liabilities. A low leverage value is deemed to indicate a healthy company due to decreased debt financing and service fees. On the other hand, Apple has a more manageable asset financing structure.

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 higher debt burdens could be financially riskier. With that said, there are certain special conditions and considerations that sometimes arise. The DuPont Analysis tells investors how well a firm is doing with respect to its Return on Equity. The equity multiplier ratio in the DuPont analysis stands for financial leverage that a firm displays in managing its finances. The asset turnover stands for asset use efficiency while the net profit margin tells the investor about the operating efficiency of the firm.

How Return on Equity Can Help Uncover Profitable Stocks

Equity multiplier can compare the financial leverage of different companies. A company with a higher equity multiplier is more leveraged than a company with a lower equity multiplier. the equity multiplier is equal to: The equity multiplier is a great way to calculate the value of an equity investment. It is calculated by dividing the company’s valuation by the number of shares you own.

• Apple, known for its strong brand and huge cash reserves, traditionally has a low equity multiplier.
• This means that for every $1 of equity, Company XYZ has $2 of debt ratio or other liabilities.
• Equity multiplier ratio is obtained by dividing the total assets of a company by shareholder equity.
• In other words, the company will need to generate a more consistent and steady profit to be able to meet its debt payment obligations (or debt service).
• However, one must note that high debt levels are not necessarily harmful.
• A low leverage value is deemed to indicate a healthy company due to decreased debt financing and service fees.