Trading on Equity is a financial process that involves taking more debt to increase the shareholders’ return. Usually, trading on Equity occurs when a company takes debt, in the form of preferred stock, bonds, or loans, and so on. Then the company uses those funds to acquire assets and as a result, generate a return greater than the interest cost of this new debt.
Trading on Equity is also known as financial leverage. Experts consider it successful if the company generates a profit, as well as a higher return on investment for the shareholders. Typically, companies go for trading on Equity to improve their earnings per share (EPS).
The term got its name because creditors lend money to a company based on its equity strength. Basically, the company takes advantage of the Equity and borrows funds on reasonable terms.
However, when the borrowed amount is large compared to the Equity, investors call the process “trading on thin equity.” On the other hand, when the borrowing is small, they say that the company is “trading on thick equity.” Such a method of financing can occur using both Equity and debt.
If a company wants to acquire a new asset or fund expansion, it can issue more preferred shares. But in that case, management usually expects that the new expansion or asset will earn more income than what it needs to pay a dividend for the recently issued preferred shares.
Debt is the most common source of funds, and it can be in the form of a loan or bonds. While issuing bonds or taking a loan, though, management expects to generate more profits than principal payments for the new debt and the interest.
What are the advantages of trading on Equity?
Trading on Equity offers two advantages: enhanced earnings and favorable tax treatment. In the first case, the company creates a chance to earn more revenue by acquiring new assets or borrowing funds.
In the second case, it works differently, though. The interest expense on the borrowed fund is tax-deductible. As a result, it diminishes the tax burden on the borrower. The debt essentially reduces its net cost to the borrower.
Does it have disadvantages?
Yes, and the main disadvantage is higher interest rates than earnings. The truth is that trading on Equity is not always favorable. If a business is unable to pay off the interest expense, equity trading may lead to disproportionate losses. Financial managers must consider that such borrowings can prove extremely risky for a business if it depends upon short-term borrowings to fund its operations. A sudden jump in the short-term interest rates may increase the burden of interest expense. It could even lead to losses.
While we can say that trading on Equity has the potential to increase the returns for shareholders, if the cash flows are below the expectations, it also presents the risk of bankruptcy.
When is the trading on Equity considered a success?
This type of financing is profitable in several scenarios:
- The business of the company is non-speculative in nature.
- A company using such financing is well-established.
- Sales and profits of the company are regular and stable.
Trading on Equity may lead to uneven earnings, though, and it increases the recognized cost of stock options. When there is a rise in earnings, option holders are more likely to cash in their options. There are more chances that options will earn a higher return for the holder, considering that trading on Equity leads to more variable earnings.
Overall, trading on Equity is like a trade-off. A company uses its Equity to get new funds for purchasing new assets. Then the company uses those new assets to pay its debt obligations.
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