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Have you ever wondered what is trading on equity? A company needs a substantial amount of capital to grow itself and become profitable. Trading on equity is one such financial strategy a company uses to gain access to the funds. Moreover, trading on equity is of two types- trading on thick equity and thin equity. Do you want to learn more about what is trading on equity? Continue reading to find out.
What is trading on equity?
You might want to know what is trading on equity. The concept of trading on equity, or financial leverage, refers to a strategy wherein debts are taken to enhance the company’s profits. This ultimately enhances the shareholder’s returns.
A firm might take debts via bonds, term loans, preference share issues or debentures. These funds borrowed by the company will be utilised for purchasing assets. It may generate returns while helping the firm to earn more revenue.
The company utilising this strategy should generate substantial revenue compared to the overall borrowing cost. This is essential when the company wants this strategy to be successful.
Here’s a trading on equity example to help you comprehend its concept:
Let’s say that business A has ₹50 crores in total equity. The corporation chooses to issue debentures to finance ₹20 crores. The debentures have an annual interest rate of 12%. Utilising the borrowed cash (₹20 crores), the firm intends to buy a few assets to increase revenue, profitability, and shareholder returns.
Now, the interest expense on the borrowed cash adds up to roughly ₹2.40 crores per annum (₹20 crores x 12%). As a result of the borrowed cash being used effectively, the company’s income has risen by around ₹3 crores annually. The company’s trading on equity method is effective since its income exceeds the cost of borrowed capital.
What is the purpose of trading on equity?
A business may use debt or equity to finance itself in its capital structure. The firm will pay fixed interest, which is less expensive than the cost of equity capital if it employs more debt to finance initiatives.
There will be profit left over for the existing owners once the set interest on the obligations is paid.
The gain will be distributed to more equity owners if more shares are issued. Due to this, when profits are high, businesses choose to raise funds for a project or spread earnings among a larger number of shareholders using low-cost debt.
1. Increasing the wealth of the shareholders is the primary goal.
2. Trading on equity is used when a corporation prefers debt financing over equity financing.
3. The business uses this tactic to guarantee it maintains control over the business.
4. Trading on equity is another tactic a business may employ to raise its market share price.
Types of trading on equity
Financial leverage is another term for trading on equity. These two expressions indicate that a business entity uses its creditworthiness to secure loans and raise shareholder profits. Put differently, the strategy’s name refers to a company using its equity power to get loans from creditors.
With that knowledge in mind, there are two types of trading on equity:
- Trading on thin equity
A corporation is said to be trading on thin equity when its debt capital exceeds its equity capital. But, the amount of debt the firm holds is more than the amount of equity in the total capital.
- Trading on thick equity
A corporation is trading on thick equity if its debt capital is lower than its equity capital. The company’s equity shares generate more profit and money than its debt or fixed securities in these situations.
Advantages of trading on equity
- Uninterrupted trading
Trading on equity results in a growth in the company’s debt capital, which also raises the company’s total capital. Because the ownership capital grows steadily, the company’s trade is uninterrupted.
- Increase in the dividend
Increased profits and money for the business raise the likelihood that dividends on equity shares will be paid out more frequently, increasing shareholders’ income from their shares.
- Reduce the burden of tax
Tax reduction is one of the main benefits of equity option trading. This is because taxes are only imposed on profit following payment of expenses.
Disadvantages of trading on equity
- Income uncertainty
A corporation can only exchange stock if its primary source of income is steady and predictable. Let’s say the business has erratic and unpredictable revenue and trades on equity. In that scenario, the stockholders will not receive dividend payments, and the interest paid on debentures would also change.
- High rate of interest
The interest rate on equities trading will progressively increase as it is a debt. This implies that there is an increased risk involved in trading stocks. Investors in the business will want compensation for taking on more risk. Consequently, the business must choose to lower the shareholders’ dividend rate.
- Over capitalisation
Trading on equity may result in the company’s debt growing relative to the value of its assets. Overcapitalisation also reduces an organisation’s ability to accept loans.
How is trading on equity different from equity trading?
People frequently mix up the phrases equity trading and trading on equity. However, there are significant conceptual differences between how to trade in equity market or equity trade life cycle. Equity trading is essentially the buying and selling stocks, even though it is a financial technique to increase shareholder earnings.
Corporate managers engage in and carry out equities trading, while any person or organisation can carry out equity trading. By trading on equity, managers try to profit from the discrepancy between interest on debt and profits on investments.
Conversely, through equities trading, whether offline or online, investors aim to profit from fluctuations in share prices by purchasing stocks at a lower price and selling them at a higher price.
Therefore, to eliminate any confusion that may be present, it is essential to understand the distinctions between and the meanings of each of these terms.
Effectively designed and implemented, equity option trading may yield significant advantages for corporations and their investors. However, the cost of the debt raised can outweigh the profits from the newly acquired assets if the proper approach isn’t taken. As a result, the corporation in issue has a setback with its equities trading strategy. Businesses must carefully arrange their debt finance and asset purchases to prevent this issue.
Organisations can use debt finance to acquire the right assets through equity trading. The revenue generated by assets may partly settle the interest on borrowed money. The interest expenditure is also deductible from taxes.
It is safe for a business to use the trading on equity method if it believes it will generate more revenue than it needs to borrow and won’t eventually fail. There is a genuine chance that the business will fail or won’t make the most profit.
There are two distinct forms of trading: trading on thin equity and trading on thick equity. The borrowed amount is comparable to its equity since the company’s capital is less than its loan capital while trading on thin equity.
On the other hand, because its equity capital is more than its debt capital, a business that trades on thick equity loans a small amount close to its equity.
A significant risk associated with trading on equity is the potential danger it may pose to an organisation if it has inconsistent or lower-than-expected earnings. For the organisation, paying interest on borrowed funds is an inevitable expenditure.
The cost burden increases when assets bought with borrowed funds aren’t anticipated to produce the expected revenue. The possibility that the company won’t be able to pay its capital costs eventually represents another risk.
The business bears Additional interest rate payments, which may impact the income statement.