Equity Multiplier Ratio

Leverage is the extent to which a business utilizes liabilities (including debt funding) relative to equity funding, to finance its operations. The equity multiplier ratio, sometimes referred to as the assets to equity ratio, is one measure of financial leverage and is an indicator of the level of assets relative to the level of equity in the business.

Equity Multiplier Formula

The equity multiplier ratio formula is the assets divided by the equity of the business.

Equity multiplier ratio = Assets / Equity

Both assets and equity are found on the balance sheet of the business.

Since assets are funded by both liabilities and equity, the higher the ratio, the higher the level of liabilities relative to equity in the business.

How To Calculate Equity Multiplier

The balance sheet below is used as an example to show how to calculate the equity multiplier ratio.

Balance Sheet
Cash 40
Accounts receivable 35
Inventory 11
Current assets 86
Property, plant and equipment 130
Total assets 216
Accounts payable 25
Other liabilities 20
Current liabilities 45
Long-term debt 51
Total liabilities 96
Capital 20
Retained earnings 100
Total equity 120
Total liabilities and equity 216

The numbers used in the calculation of the equity multiplier ratio are highlighted in the balance sheet shown. In the above example the assets are 216 and the equity is 120.

Using the formula the equity multiplier is calculated as:

Equity multiplier ratio = Assets / Equity
Equity multiplier ratio = 216 / 120
Equity multiplier ratio = 1.8

In this case the ratio is 1.8. Assets are greater than the equity, and therefore liabilities must have been used to fund the business.

It should be noted that the inverse of the equity multiplier gives the percentage of assets which have been funded by equity. Using the above example, this can be calculated as follows:

Assets funded by equity = 1 / Equity multiplier
Assets funded by equity = 1 / 1.8
Assets funded by equity = 56%

It stands to reason that the balance of assets 44%, must have been funded by liabilities, including debt.

Alternative Form For The Equity Multiplier

If follows from the accounting equation that Assets = Liabilities + Equity. If we substitute assets for liabilities plus equity in the equity multiplier formula we get the following:

Equity multiplier ratio = Assets / Equity
Equity multiplier ratio = (Equity + Liabilities) / Equity
Equity multiplier ratio = 1 + Liabilities / Equity

Using this alternative form we can get some useful information about the equity multiplier. Assuming equity is not negative.

  • If liabilities = 0, the equity multiplier is equal to 1
  • When liabilities < equity, the equity multiplier is between 1 and 2.
  • When liabilities = equity, the equity multiplier is equal to 2
  • If liabilities > equity, the equity multiplier is greater than 2.

Real Life Equity Multiplier Ratio Examples

The equity multiplier ratio will vary from industry to industry, and therefore it is important when making comparisons to determine an industry equity multiplier ratio based on financial statements of businesses similar to your own.

To illustrate the difference in the equity multiplier ratio from industry to industry, the following table sets out the calculation of the ratio based on the Apple Inc. and Amazon balance sheets.

Equity multiplier ratio comparison
Apple Amazon
Assets 207,000 40,159
Equity 123,549 9,746
Equity multiplier 1.68 4.12

The equity multiplier of Amazon (4.12) is significantly higher than Apple (1.68) indicating that Amazon is more highly leveraged than Apple. If we take the inverse of the equity multiplier as discussed above, we can find the percentage of assets funded by equity and liabilities for each company as follows.

Apple:
Assets funded by equity = 1 / Equity multiplier
Assets funded by equity = 1 / 1.68
Assets funded by equity = 60%
Assets funded by liabilities = 40%
Amazon:
Assets funded by equity = 1 / Equity multiplier
Assets funded by equity = 1 / 4.12
Assets funded by equity = 24%
Assets funded by liabilities = 76%

The ratio should be monitored to ensure that it is consistent with the industry in which the business operates.

A business with a high equity multiplier has a high level of liabilities (including debt) relative to its equity and is said to be highly leveraged. As liabilities need to be repaid before equity, a highly leveraged business is considered to be more risky for the owners and investors.

High leverage is not necessarily a bad thing. Providing the return the business makes is greater than the cost of the debt (interest), high leverage can lead to greater returns for the owners of the business.

Equity Multiplier Ratio May 6th, 2017Team

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