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.
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.
|Property, plant and equipment||130|
|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.
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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.