The process of buying or investing in a business can intimidate people who don't have a finance background. Fortunately, a simple tool called the equity multiplier can help both novice and experienced investors evaluate the level of a company's risk.
Calculating the Equity Multiplier Ratio
The equity multiplier measures how much of a business' assets are financed by equity - either by the owners or the shareholders - versus debt, such as loans. Similar to other accounting tools like the debt-to-equity ratio, the equity multiplier paints a picture of a company's financial risk. Companies that rely heavily on debt financing must generate enough cash flow to cover their debt obligations while keeping the operation running.
- Company A has total assets of $100,000; it has taken out $30,000 in loans, and the remaining assets (worth $70,000) have been funded directly by the owner. Thus, Company A has an equity multiplier of 100/70, or 1.4.
- Company B also has total assets of $100,000, but has loan obligations of $80,000. Therefore, Company B has an equity multiplier of 100/20, or 5.
Practical Uses for the Equity Multiplier
Once you have determined the equity multiplier ratio, you can employ it in your investment analysis. Generally, the lower the equity multiplier, the more conservative - and less risky - the investment. In the example above, Company B would be the riskier investment because of its high debt level. This may or may not be a significant concern, based on the situation and investment objectives.
- Chris has $20,000 to invest in a business. She is a hands-on manager who desires an ownership stake and a say in how things are done. Chris may be more inclined to invest in Company B; the new equity multiplier after her investment - 120/40, or 3 - has reduced the debt risk and given her half of the remaining equity.
- On the other hand, Sam wants to buy a business outright. He may lean toward Company A because its low equity multiplier represents less risk. Sam understands that the enterprise must cover its debt obligations in both good and bad times. And if he needs to secure financing, loan companies will look more favorably on a business with a lower equity multiplier.
One Piece of the Puzzle
The equity multiplier is only one factor to consider in a business evaluation. Beyond financial information like debt and cash flow, investigate the company's marketing plan, customers, suppliers, and any outstanding legal or regulatory issues. While the challenges of finding an appropriate investment may seem overwhelming, the hard work can result in great rewards.