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 is the ratio of total assets by total Equity. Mathematically,

Equity Multiplier = Total Assets / Equity.

It measure the degree of financial leverage the company have. In simpler terms, it measures how much of total assets of a firm are financed by Equity. A higher ratio means, lesser ratio of equity adn a higher degree of financial leverage.

b. If equity multiplier is 3, it means the total assets of the firm are 3 times of equity or 1/3 of total assets are financed by equity and 2/3 are by debt.

c. The profitability (i.e. Return on Equity) has a direct relationship with the equity multiplier. As per Du Pont Analysis

Return on Equity = Equity Multiplier*Profit Margin * Assets Turnover

Keeping other factors constant, a higher equity multiplier means a higher profitability