Question

1. What is the equity multiplier? What does it measure?
If the equity multiplier is 3, what does that mean?
Explain the relationship between the equity multiplier and profitability?

Answer 1

Equity Multiplier

Equity multiplier is a financial leverage ratio which indicates the percentage of the assets which are being financed or is owed by the share holders.Equity multiplier is used to measure the amount of the assets of a firm which are being financed by their shareholders by just comparing the total assets of the firm with that of the total shareholder's equity.

Equity Multiplier - Interpretation

A higher equity multiplier for a firm would mean that the financial leverage which means that the debt portion of total assets is increasing which means that the firm is highly dependent on the debt for financing its operations which may lead to an excess debt burden for the company. A lower equity multiplier means that the company is solely working on the financing by its stockholders and is less dependent on debt which is a conservative investment for the company. An Equity multiplier of 3 means that the total assets of the company is 3 times the total shareholders equity and this is the optimal balance of debt and equity for any firm to be capable of financing the assets.that i.e 2:1.

Equity Multiplier and Profitability - Relationship

A higher level of equity multiplier does not always mean that the firm has a higher debt burden. Sometimes a firm which has a high level of equity multiplier is viewed as a case of an effective business strategy of the firm where the company has borrowed the debt to purchase its assets at a lower cost of capital. This is a special case wherein the firm finds it very profitable to incur a debt as a source of financing rather than issuing a stock.If the company is able to effectively produce profits which is enough to service its debt and so incurring a debt is considered as a profitable strategy for the firm. A lower level of equity is not always a positive strategy as the company may find it difficult to locate a suitable lenderwho is willing to loan funds to the firm to finance their operations.