What is trading on equity?
Trading on equity is a financial process in which debt produces gain for shareholders of a company. Trading on equity happens when a company incurs new debt using bonds, loans, bonds or preferred stock. The company then uses these funds to gain assets which will create returns which are larger than the interest of the new debt. Alternatively, trading on equity called financial leverage. If it helps the company to generate profit and results in a higher return for the shareholders on their investment, it is considered a success. Companies usually go this way to boost earnings per share.
‘Trading on equity’ is called so because the company gets its loan amount from the creditors based on its equity strength. Companies usually borrow funds at favourable terms by taking advantage of their equity. If the amount borrowed is large as compared to the company’s equity, it is categorised as ‘trading on thin equity.’ When the borrowed amount is modest, the company is ‘trading on thick equity.’
Advantages of Trading On Equity
Trading on equity offers a company two advantages
Enhanced earnings: By borrowing the funds necessary, the company creates for itself more avenues of earning revenue by obtaining new assets.
Tax treatment is favourable– The borrowed funds have an interest expense that is tax deductible. So, the borrowing company has to pay lower tax. So, basically, the new debt results in a reduction of the total cost for the borrower.
Trading on equity has its own set of risk factors. It may result in further losses if the interest expense cannot be paid off by the business. You should note that such borrowings can cause high-risk situations for a business, which is depending on the borrowed amount to finance its operations.
If there is an unexpected rise in the interest rates, it can cause losses because the financial burden of the interest would increase for the company. So, while trading on equity holds the promise of potential increased returns, there is also a real risk of bankruptcy you must take into account.
When Can You Consider It A Success?
Trading on equity is likely to be profitable in the following cases-
- When a company that is well-established resorts to such means financing
- The nature of the company’s business is not speculative
- the company has profits and sales that are both regular and stable
It is because of the above points that public utility concerns frequently use this financing concept. These organisations have ample liquidity to allow for large scale borrowing.
Trading on equity may result in uneven earnings, so it impacts the stock options by increasing their recognised cost. When an increase in earnings occurs, it is option holders who are most likely to cash their options. Since the earnings are not fixed, the chances of the holder earning a higher return are greater.
So, it is more likely that managers will use this option more that owners. Using the process, managers have the opportunity to increase the worth of the stock options. A business that is run by a family, on the other hand, has financial security as its high priority, so, it is unlikely that they would go this route.
As the bottom line, we can view trading on equity as a sort of trade-off. A company uses its equity as a way to get more funds in order to purchase new assets, and uses these new assets to pay for its debt.