Demystifying the equity multiplier
Just because there isn’t quite enough to consider (you know, only hundreds of variables) when trying to decide whether to invest in a certain company, how about learning about one more equation that could help you out? With this particular equation, you can measure a company’s financial leverage.
Sure, why not?
Have you ever heard of an equity multiplier?
No? Yeah, me neither.
The equity multiplier measures a company’s financial leverage by dividing a company’s total assets by its shareholders’ equity, and basically, it’s used to evaluate a company’s use of debt to purchase assets. In some cases, the larger the multiplier, the easier it is for that company to start feeling the heat if any parts of their business begin to go against them.
Fortunately, the equation is fairly intuitive based on the definition:
Equity Multiplier = ______Total Assets____
Oh, good. I’m glad you asked. Leverage refers to a company’s investment strategy of using borrowed money to increase the potential return of an investment, and can also refer to the amount of debt used to finance assets (which is what we’re mostly referring to in this case.)
In short, leverage is using somebody else’s money to operate or try to grow a company’s business. Again, sometimes this is a good thing, while in other cases (like seen in the financial crisis), have high levels of leverage is a bad thing.
Equity Multiplier in Action
Let’s apply the multiplier to the real world using my favorite two businesses, Molly’s Cupcakes and Scratch Cupcakery.
Molly’s Cupcakes is a brand new business, and because you’re a cupcake junkie, you’re seriously considering investing in Molly’s. Before you pony up your cash, however, you know you need to do some sleuthing.
The business has had a lot of startup expenses and all of the rocky first-year fun that a lot of small businesses experience. Molly’s claims $10,000 in total assets, and $2,500 in shareholder equity. Therefore, the equity multiplier is 4, which means that Molly’s uses equity to finance 25 percent of its assets and the other 75 percent is funded by debt.
Conversely, Scratch Cupcakery, which happens to be in the same town as Molly’s, has been in business forever. It’s a leader in the industry and serves as a good benchmark for Molly’s. As an investor in Molly’s, you’d be smart to compare the two, if you can get your hands on Scratch’s financial statements.
Let’s say that Scratch Cupcakery has $10,000 in total assets (just to keep the economics simple) and $5,000 in shareholder equity. $10,000 divided by $5,000 is 2, and 2 is the equity multiplier.
Since Molly’s Cupcakes has a higher multiplier, the conclusion can be drawn that Molly’s relies more heavily on debt to finance its assets.
So, if you’re dying to get into the cupcake business, which company should you invest in, provided both companies are looking for investors? (As in, which of the two companies is risking less—however, you may also have to take into account how much debt is common within that industry.)
Ultimately, if you said that Scratch Cupcakery is less of a risk, then bingo! You were listening in accounting class—well done.
High Equity Multiplier/Low Equity Multiplier
If the multiplier is high, it implies that assets are being funded with a high proportion of debt. If the ratio is low, it also could mean that the company is either:
- Trying to avoid going into debt or
- Is unable to get a loan.
What’s the Relationship Between Debt Ratio and Multiplier?
Ooooh, good question.
What’s debt ratio, anyway? The technical definition for debt ratio is “the proportion of a company’s assets that is financed through debt.”
Let’s put the multiplier and the math associated with just the equity multiplier aside for about ten seconds, and actually blend both equity multiplier and debt ratio into one equation. Don’t you just love algebra?
First, the debt ratio equation can be found below:
Debt ratio = Total debt
Next, you can use the multiplier to figure out the debt ratio by using the following formula:
Debt ratio = 1- (1/ equity multiplier)
So now, we’ll go back to our two cupcake company examples again and apply the formula.
Debt ratio for Molly’s Cupcakes = 1- (1/4) = 0.75= 75 percent
Debt ratio for Scratch Cupcakery = 1- (1/2) = 0.50 = 50 percent
Again, you can see that Molly’s higher debt ratio reflects a larger financial risk to you if you do wind up investing in Molly’s.
So, What is a Good Debt Ratio, Anyway?
Well, that depends. Obviously, a larger company can go a little further and more comfortably accept larger amounts of debt than a smaller company can. Ultimately, both of our companies in both of our examples are high (Molly’s is uncomfortably high) in the debt department.
Now, interestingly, in some situations, low debt-to-equity ratios may indicate that a company is not taking advantage of potentially increased profits that financial leverage can bring. Lots of small businesses try to get out of debt as quickly as possible, but that actually may not be the savviest or most efficient way to grow their businesses. (Can you see how there’s a whole science out there regarding how companies use debt intelligently to fund their businesses? Wow. There really is magic there!)
However, in Molly’s case, you may not be able to argue that they are using debt intelligently, because of its small size, relative newness, and really, really high debt ratio.
Comparing Cupcake Competitors
I mentioned something earlier about comparing Molly’s and Scratch Cupcakery to others in the industry to determine whether their risk levels are similar. Comparing each multiplier to that of other cupcake businesses is a really good idea for determining how much risk should be tolerable.
If Molly’s multiplier is 4, is it higher than the industry average? Is Scratch Cupcakery’s multiplier, at 2, lower than the industry average, or is that still high? (For publicly traded companies, it’s easier to find this information and do research on financial websites which provide stock quote information.)
In addition, since Scratch Cupcakery has been in business for quite a while, and Molly’s is newer, it might be a good idea to dig into some history and calculate the equity multiplier for Scratch in past years to see if there are any changes in the equity multiplier over time.
Should I still invest in Molly’s?
The good news is, you’re on the right track! You’re asking the right questions in calculating the equity multiplier, the debt ratio and asking lots of good questions about Molly’s and, to compare, Scratch’s balance sheets.
When you make a debt investment, which is what you’re considering, you loan the business money in exchange for repayment of the principal investment, plus any interest income that accrues on top of the principal. Right?
Right. If Molly’s fails (and we really hope that doesn’t happen) the repayment of the debt has priority. For example, if you’re given a lien on the real estate and cupcake building, you can foreclose on it if Molly’s goes under and should get your money back. There are risks, yes, but you’re more likely to come out money ahead if you’re a debt investor rather than if you were an equity investor, otherwise known as a stockholder.
Only you can determine whether Molly’s is a good investment–maybe you have inside knowledge of Molly’s Cupcakes’ management team, know the business plan by heart, have evaluated all the tax consequences, and know all the positive benefits of investing in Molly’s, etc., etc.
Fortunately, you have infinite tools at your disposal in this day and age–including our little lesson on the equity multiplier.
The Hard Truth About Debt and Leverage
While this is a fun article comparing two mom and pop cupcake shops, debt and leverage are two topics that will never go away and can sometimes lead to bad things happening.
If we look at the interest rate environment that we are currently living in, we can see rates at levels we have never seen before (never lower). Acquiring debt and leverage at these levels may not be as bad as acquiring a similar amount of debt and leverage if interest rates were double what they are now (overnight interest rates at 0.75% right now).
However, as interest rates increase, companies are left with two scenarios to consider:
- The interest on continuing to issue debt goes higher
- They may not be able to have as much capital as they did when interest rates are lower
The two scenarios above can make or break companies that rely on cheap and relatively free money. If a company decided they cannot bring on as much debt or leverage compared to when interest rates were lower, somewhat of a butterfly effect occurs.
Companies hire fewer people and do not give as many raises. Those people have less money to spend. They go out to dinner less and buy less overall. Those businesses where they used to eat or buy from having to cut back as well because they have less revenue coming in. Employees of those companies also feel some financial setbacks. And because of this all, we have multiple people with less money to spend.
This is a scenario we see time and time again when it looks like economies are on their way to slowing down.