There are a variety of formulas and ratios used by investors to analyze a company. One of these is the equity multiplier. A way to determine leverage, and the manner in which a company finances itself, it can be a useful tool in analyzing the risks of an investment. What Is the Equity Multiplier?

In simple terms, the equity multiplier helps determine what portion of a company’s assets have stemmed from shareholders. To do this, you compare a company’s assets with stockholders' total equity. You can use it to figure out how much a company uses shareholders for financing, as opposed to how much it uses debt financing.

If the ratio is high, it tells analysts that a company is using more debt financing, creating leverage. If the ratio is lower, it means the company has less need for debt financing, offering a more conservative investment that avoids things like debt payments. Formula and Example

The formula for the equity multiplier is pretty simple.

Equity Multiplier=Total Assets/Total Stockholders Equity

You’re going to find these figures on the balance sheet. Let’s look at an example using the fiscal 2019 results for Macy’s( M ) - Get Report, versus the results of competitor Kohl’s( KSS ) - Get Report.

For fiscal 2019, Macy’s reported total assets of $19.86 billion. The retailer had stockholder’s equity of $6.44 billion. While the term “equity multiplier” might sound complicated, it’s just simple division.

Plug in your figures:

Equity Multiplier=Total Assets/Total Stockholder’s Equity

Equity Multiplier=$19.86 billion/$6.44 billion

Equity Multiplier=3.08

This means that 32.4% of Macy’s financing was done with equity (6.44/19.86). The other 67.6% was done with debt.

In comparison, Kohl’s had total assets of $12.47 billion in fiscal 2019. Total stockholder’s equity was $5.53 billion. Once again, you simply plug in the numbers.

Equity Multiplier=$12.47 billion/$5.53 billion.

Equity Multiplier=2.25

Kohl’s uses equity for 44.35% (5.53/12.47) of its financing, and 55.65% of its financing was done with debt.

If you look at the relative comparison, Macy’s higher equity multiplier of 3.08 is indicative of the higher levels of debt financing that the company uses compared to Kohl’s multiplier of 2.25. Why Do Equity Multipliers Matter?

Keeping with the example set forth above, equity multipliers can be useful tools in analyzing risk. A company that leverages more debt to finance itself is taking on more liabilities. There are corresponding debt payments that have to be made that don’t add to the business. Whereas financing done with equity can be put more fully into business activities. It also cuts down on the risks of debt payments and defaults should profits decrease to a point where making payments is difficult.

If you’re looking for conservative, low-risk plays, a company with a low equity multiplier is usually the way to go. That’s not to say that companies with high equity multipliers are always bad investments. Say for instance that there’s a special market situation where a competitor’s valuation is cheap relative to its performance. A company might use debt in this situation to acquire that competitor and boost their profits at a higher rate than the debt they incur. There’s still risk, but it’s a strategic risk.

Another example might be stock buybacks. Say a company’s shares drop below the book value of the business. It might be useful to use debt to buy back shares.

On the flip side, a thought that could be used against companies carrying low equity multipliers; perhaps the company has no choice but to use equity. If the equity multiplier is super low, there’s a possibility that the company can’t obtain debt financing. That could be a big red flag. If a bank or lender won’t give the company money, there might be something wrong. The Takeaway

Unless you harbor Warren Buffett’s passion for return on equity, focusing on one ratio or calculation for analyzing investments isn’t a very balanced approach. Simply focusing on a company’s use of stockholder’s equity comparative to the use of debt financing won’t give you a full picture of the appeal of a stock. Plenty of companies have leverage and still do well if they’re creating big earnings from it. Home Depot( HD ) - Get Reportis a prime example of this. The home goods retailer has carried a deficit on the balance sheet for a while now, and continues to put together strong results. It doesn’t mean it will last, and the consequences of that leverage could be disastrous.

In the end, the equity multiplier is simply a tool to show you the manner in which a company spreads its financing between equity and debt.