Trading on Equity (2024)

Usually, the primary aim of a company is to earn a profit, and sometimes, some companies do it using their debt capital rather than their equity capital. By trading equity, companies essentially expect to increase their income by buying more assets and generating returns on these investments, which are more than their debts. This helps the company earn more profit and ensures that the shareholders get more earnings per share. However, if the company cannot get more returns than debts, it results in lower earnings, and the shareholders are directly affected and get fewer earnings per share.

Types of Trading on Equity

Trading on equity can be divided into two types on the basis of the debt funding used:

• Trading on thin equity

When a company’s debt capital is more than its equity capital, it is said to be trading on thin equity. In simple words, the portion of the equity in the overall capital is less than the portion of the company’s debt.

• Trading on thick equity

When a company’s debt capital is less than its equity capital, it is said to be trading on thick equity. The company collects more profit and funds from equity shares than its debt or fixed securities in such cases.

Advantages of Trading on equity

• Uninterrupted trading

Because of trading on equity, the debt capital of the company increases, which also leads to an increase in the company’s overall capital, since there is a continuous increase in the ownership capital, the company’s trade operates without any interruption.

• Increase in the dividend

With the increase in the profit and funds of the company, it is more likely to increase the payment of dividends on their equity shares which results in an increase in the income of the shareholders from the shares.

• Reduce the burden of tax

One of the major advantages of trading on equity is reducing taxation. This is because tax is only enforced on profit after paying the expenditure.

• Increase in goodwill

With the increase in a company’s income and profit, the company decides to pay the dividend at a higher rate. Doing this results in an increase in the goodwill of the company. As the goodwill increases, so does the per-share rate of the company. An increase in goodwill also means that the company will easily enjoy obtaining loans.

• Control on sources

Trading on equity opens up companies to more sources. Such trading might help them gain more control over their sources and maximise their usage.

• Business control

By the use of trading on equity, the owners of the business enjoy better control over their business. That is because the increase in the debt capital results in a decrease in the equity capital. This means that only a small group of people with shares have the voting power, and thus, the owners exercise more power.

Disadvantages of Trading on equity

• Income uncertainty

A company will only be able to trade equity if its income from the main business is stable and constant. Suppose the company trades on equity with an unstable and irregular income. In that case, the dividends will not be paid to the shareholders and payment of interest on debentures will also face some difference.

• High rate of interest

Since trading on equity is a debt, its interest will gradually rise. This means that trading on equity brings with itself a higher risk. People who invest in the company will want a reward for this increased risk. As a result, the company will have to decide to reduce the dividend rate of the shareholders.

• Over capitalisation

Trading on equity might lead to an increase in the company’s debt compared to the worth of the assets of the company. Over capitalisation also limits a company’s loan taking capacity.

Trading on equity and Equity trading: the difference

These two terms: trading on equity and equity trading, are often confused and interchanged. But, these two terms explain completely different concepts of a company. Trading on equity is a strategy used to increase the debt share and enhance the earnings of a shareholder. On the other hand, equity trading is the selling and buying of the company’s shares.

Trading on equity is a process that is undertaken and executed by managers of the company, whereas an individual can do equity trading. The company seeks to profit from the difference between the interest on debts and the returns on investments when trading on equity. While a company equity trades, the investors look forward to financing the shares by buying them at a discount and selling the shares at a premium.

Usually, investors go for shares with a greater interest rate than a fixed charge of interest because it means they will earn extra money in the form of a dividend and more dividend means an increase in the shares’ price.

Conclusion

Trading on equity is a financial tool that companies use to increase their debt capital. The debt that the company produces is done to increase profit/gains for the company’s shareholders. After incurring debts such as loans, debentures, bonds, etc., the company increases their assets, creating a greater return on investment than the rate of interest on the debt. Based on the debt capital used by the company for the trading, trading on equity can be divided into two types: trading on thin equity (more debt capital as compared to equity capital) and trading on thick equity (less debt capital as compared to equity capital).