The equity multiplier is the ratio of a company's total assets to its stockholders' equity. The ratio is intended to measure the extent to which equity is used to pay for all types of company assets. If the ratio is high, it implies that assets are being funded with a high proportion of debt. Conversely, if the ratio is low, it implies that management is either avoiding the use of debt or the company is unable to obtain debt from prospective lenders. The formula for the equity multiplier ratio is:
Total assets ÷ Total stockholders' equity
This information is located on a company's balance sheet, so the multiplier can be easily constructed by an outsider who has access to a company's financial statements. For example, ABC International has $1,500,000 of total assets at the end of the month, as well as $750,000 of stockholder's equity. The resulting 2:1 equity multiplier means that ABC is funding half of its assets with equity and half with debt.
A high equity multiplier, especially in comparison to the results for other companies in the same industry, implies that a business may have incurred more debt than is the norm, which could be difficult to support if there is a downward trend in the business cycle.
The ratio can be skewed or misunderstood in the following ways:
- Depreciation. If an organization uses accelerated depreciation, since doing so artificially reduces the amount of total assets used in the numerator.
- Payables. If the ratio is high, the assumption is that a large amount of debt is being used to fund payables. However, the organization may instead be delaying the payment of its accounts payable in order to fund the assets. If so, the entity is at risk of having its credit cut off by suppliers, which could trigger a rapid decline in its liquidity.
- Profitability. If a business is highly profitable, it can fund most of its assets with on-hand funds, and so has no need for debt funding. This concept only applies if excess funds are not being distributed to shareholders in the form of dividends or stock repurchases.
- Timing. If an organization conducts a large part of its billings at a certain time of the month (such as at month-end) this can skew the total assets figure upward, due to a large increase in accounts receivable.