Every company aims to keep their shareholders happy. One way to do it is to increase their earnings, increasing shareholder earnings is one critical task of the management of any company, and there are several strategies that corporations deploy and utilize to do the same. One of the popular strategies is trading on Equity, for which the Corporation or the company procures new debt through dentures, preferential shares, bonds, or even loans. Companies use this debt to purchase new assets or invest in a new venture.
What is Trading on Equity?
Through Trading on Equity, companies try to increase their income by acquiring assets that will generate returns higher than the debt they take on. This profit or the excess revenue adds up to the earnings per share of the shareholder. This increase indicates that the strategy deployed by the Corporation has been profitable.
But if this strategy does not work out as planned, it could lower the EPS, thus reducing the shareholder’s income and costing the corporation interest expenses. This indicates a failed strategy.
Types of Trading on Equity
Trading on Equity, in other terms, is also called Financial Leverage. Both these terms indicate that a corporation leverages its financial position and health to take on further debt to enhance the shareholder’s earnings. The name comes from the fact that the company uses its equity strength to take debt from creditors.
There are two types of Trading on Equity
- Trading on thin Equity: In this type of Trading on Equity, the Corporation’s Equity is less than the debt capital. Simply put, the Corporation has more fixed-cost securities (Debt, Debentures, or preference Shares) than equity capital.
- Trading on thick Equity: When the share capital of the Corporation is more than the debt capital, it is known as thick Equity; in other words, the Corporation gets more funds from the equity shares and less from the fixed-cost securities.
Advantages of Trading on Equity
Trading on Equity holds a lot of advantages and benefits to the Corporation and several of the concerned parties, such as
- Taxation: Debt capital is a preferred source of financing for the companies, as having debt is counted as an expenditure, and it reduces a company’s liability.
- High rate of Dividend Payment: By using the policy of Trading on Equity and making dividend payments at a high rate on the equity capital, the company can easily increase its income. As a result, the income of shareholders also increases.
- Better Goodwill of the company: Since Trading on Equity allows higher dividend payouts, it also impacts Goodwill positively. An increase in Goodwill of the company also increases the per share price of the company. This allows the company to easily obtain debt from the markets, and the owners can easily expand the trade with the help of the Debt Capital.
People often get confused between Trading on Equity and equity trading. These terms mean entirely different as they represent different concepts. Trading on Equity is a corporate finance strategy to enhance shareholder earnings. Equity trading is the buying and selling of listed stocks, and equity shares are done through a Trading account online.
If not done properly, trading on Equity may lead to uneven earnings, as it impacts stock options directly by increasing their recognized cost. Whenever there is an uptick in the earnings, shareholders are more likely to cash out the options. Businesses that prioritize financial security are less likely to go down this road.
We can think of Trading on Equity as a type of trade-off. A business can use its Equity to raise funds to obtain new assets to pay debts.