What is Trading On Equity? All You Need To Know About It
What Is Trading On Equity?
Equity trading is considered one of the best economic strategies an organization could take to yield better profits. In most cases, companies are able to procure debts in the form of loans, bonds, debentures, and more. So, with these assets, companies are more or less trying to increase their source of capital, which can then be invested further. The additional capital coming from the company's work will lead to an increase in Earnings Per Share (EPS) for the shareholders. All of this reflects one thing, and that is trading on equity is the right thing to do.
However, if the organization doesn't tread carefully, it could quickly convert into major losses. People who are from a commerce background could understand the working of trading on equity, but for others, this term might seem a little confusing. With this article's help, we aim to solve the confusion surrounding trading on equity, so let's begin.
Different Types of Equity Trading
Trading on equity is also known to be a financial leverage, and companies use their equity strength to get debts from their creditors. There are two main types of trading on equity, and below we have explained both of them in brief.
Trading On Thick Equity
Having thick equity means a company has a much higher equity capital than its debt capital. For example, if there is a company that has around 100 million dollars in revenue and their debt capital is just 20 million dollars. As a result, the company is trading on thick equity.
Trading On Thin Equity
The thin equity scenario occurs when the equity capital present for a company is quite lower than its debt capital. For example, when an XYZ company has an equity debt of 50 million dollars. The same company has only 25 million dollars as equity capital. In that case, the XYZ company is trading on thin equity.
Importance of Trading On Equity
Given below are the two major advantages that companies get to avail when they go for trading on equity.
Tax/ Fund Factor
When a company borrows funds from different means, they have to deal with the interest which is imposed on the amount given in the form of the fund, and this given amount is tax deductible. As a result, the borrowing company has to pay the lower tax, which leads to the borrowing company enjoying the reduction in the total cost, which they have taken as a debt.
Lower debt-servicing cost
With the use of trading on equity, companies get to take advantage of the lower debt servicing factor. Also, it is able to create multiple sources by attaining new assets that lead to an increase in revenue.
Trading on Equity: Things to Keep in Mind
With every trading scheme or method comes advantages and disadvantages along with some risk factors as well. Keeping all of this in mind, we have curated a list of things that you need to keep in mind when you or your company is going for trading on equity.
- The one thing which you can't control in trading on equity is the uncertainty of the company in which you have invested in making a profit or loss. This is always going to be the big question in your mind before you put the money into it.
- Apart from this, if the principal amount and the leased amount are not down at a convenient level for the business to pay, it could be threatening for your business as it leads to money drainage in most cases.
- When the interest rates rise in servicing debt, the interest burden will also increase on a business. There could be a massive loss, and it could easily make a company go bankrupt.
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After you have read this article, you are surely thinking about the disadvantages of trading on equity. But truth be told, you can easily resolve this problem via multiple methods. We did our part of showcasing the use of trading on equity, its benefit, and limitations. Now it is up to you to decide whether it is something you should invest in or not.
Before we sign off, we would like to conclude with one thought which is if you are a new business and just starting out, then trading on equity might not be the right thing for you as you are not aware of the proportion of the loss it could do to your business in terms of capital.
This is not an investment advisory. The blog is for information purposes only. Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Past performance is not indicative of future returns. Please consider your specific investment requirements, risk tolerance, goal, time frame, risk and reward balance, and the cost associated with the investment before choosing a fund, or designing a portfolio that suits your needs. The performance and returns of any investment portfolio can neither be predicted nor guaranteed.
How can trading on equity be used by an organization?
With the help of trading on equity, organizations have the potential to make higher profits which results in the increase of their Earning Per Share (EPS) by raising more mutual funds via borrowing.
What is the company's cost of equity?
The cost of equity for a company is basically the return that which company acquires for an investment they have made or the return that an individual requires in order to have an equity investment. The formula used for its calculation can be a dividend capitalization model or the CAPM.
What are the four main principles of trade?
To be a successful trader, you need to attack the market from multiple angles. Irrespective of the approach, trading with the trend, cutting losses short, letting profits run, and managing risk are the forum's main principles on which trade needs to be done to have better chances of making a profit.
Which one to choose from, trading on equity and capital gearing?
Capital gearing is the amount of debt that a company has over the amount of relative equity. This is a British term, and in the US, capital gearing is called "financial leverage." On the other hand, trading on equity means the use of some fixed cost sources that are used for managing finances. These could be debentures, long-term loans, preference shares, and more to increase the return on equity shares.