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## What is Equity Multiplier?

Equity multiplier is used to indicate the proportion of the company assets that is financed by equity instead of debt. Generally companies can use either debt financing of equity financing to build assets and grow. Too much use of debt financing can leave a company highly leverage, so typically investors like to see higher proportion of the assets being financed with shareholder equity.

As far as financial ratios go, equity multiplier is similar to debt ratio as an indicator of leverage. However, it is expressed differently. Equity multiplier is calculated by dividing the total assets by the shareholder equity. So a high equity multiplier will imply a low proportion of shareholder equity, and therefore high leverage.

## Equity Multiplier Formula

The equity multiplier formula can be expressed simply as:

Equity Multiplier = Total Assets / Stockholder’s Equity

If you recall, Total Assets = Total Liabilities + Stockholder’s Equity. This is the balance sheet equation.

Therefore, you can also write the equity multiplier formula as:

Equity Multiplier = (Total Liabilities + Stockholder’s Equity) / Stockholder’s Equity

= (Total Liabilities / Stockholder’s Equity) + 1

Since Total Liabilities / Stockholder’s Equity is none other then Debt/Equity Ratio, we can rewrite the formula as

Equity Multiplier = Debt/Equity Ratio + 1

This final formula clearly illustrates that the Equity Multiplier and the Debt/Equity Ratio both describe the financial leverage of a company in equivalent manner.

## Example of Equity Multiplier Calculation

Suppose a company has the following balance sheet equation:

Total Assets = $100 million

Total Liabilities = $20 million

Total Stockholder’s Equity = $80 million.

In this case, the Equity Multiplier = $100 million / $80 million = 1.25

Without knowing much more, I would say this equity multiplier looks reasonably good.

On the other hand, suppose another company has the following balance sheet equation:

Total Assets = $100 million

Total Liabilities = $80 million

Total Stockholder’s Equity = $20 million.

In this case the Equity Multiplier = $100 million / $20 million = 5

This could be excessive leverage.

## The Eternal Dilemma: Financing Company Assets with Debt or Equity

A company has a choice when it needs capital funding – either use debt, or issue equity to fund asset purchases and growth. There is an intricate balance. A higher equity component is generally a good idea as it avoids excessive leverage and a drain on the cash flow in terms of interest payments that debt funding will entail. However, it is also to be noted that in many cases, debt financing is cheaper than equity financing and the company does not need to give up ownership with debt. Debt financing also tends to lower the Weighted Average Cost of Capital, or WACC, for the company, and it can pursue more projects for economic profits.

## Can a Company Have Negative Equity Multiplier?

In rare cases a company can have a negative equity multiplier. Since the total assets can not be negative, a negative equity multiplier results from a negative stockholder’s equity.

How does this happen?

Recall that Shareholder’s Equity is made up of Paid in Capital, Treasury Stock and finally Retained Earnings. Retained Earnings is the accumulated net income in the past years that has not been paid out to the shareholders. If the company has generated significant losses in the past, and has done so for many years, it is quite possible that the Shareholder’s Equity may end up being a negative number.

In this scenario, the Total Liabilities of the company exceeds the Total Assets of the company. Unless the company can figure out a way of regaining profitability quickly, it is highly unlikely that the company can survive as a going concern.

So yes, negative equity multiplier is possible, but it means that the company is insolvent and will soon cease to exist unless there is a major change in fortunes.

## Equity Multiplier and the Dupont Analysis

The Dupont Analysis expresses the Return on Equity as

ROE = Net Profit Margin x Total Asset Turnover Ratio x Financial Leverage Ratio

The Financial Leverage Ratio is expressed as Average Total Assets / Average Shareholder’s Equity, which is pretty much the Equity Multiplier.

This relationship succinctly expresses the fact that a higher Equity Multiplier can mean a higher Return on Equity and can be a good thing.

## How to Use Equity Multiplier in Investing?

For the most part, a simple understanding that high equity multiplier ratio is less desirable than a low equity multiplier ratio is enough to steer you towards better investments. However, your analysis also needs to compare a company with its peers. Some industries are very capital intensive and require high dependence on debt to make capital investments. These industries could include Shipping, Heavy Industrial, Airlines, etc. The Equity Multipliers for all companies in these industries will be high. You want to compare equity multiplier of a company with its peers in the same industry to see if this company is less leveraged than the others.

Also keep in mind that using some debt to finance growth is a desirable attribute for a asset heavy company. You can see this in the Dupont model above. Introduction of debt increases the equity multiplier and that in turn increases the ROE for the company. However, at some point, leverage can become too high. I generally prefer that the debt be less than half of the total assets, so this means I want my equity multipliers to be less than 2.