There are several types of financial strategies that corporations utilise to magnify the earnings of shareholders. One such strategy is trading on equity, for which companies procure new debts in the form of debentures, preference shares, bonds, or loans. Consequently, companies use this debt avenue to purchase new assets or invest in a new venture.
What is Trading on Equity?
By means of trading on equity, as mentioned before, companies expect to increase their income by acquiring new assets, and subsequently generating returns that are higher than the debt they procure. Thereby, that excess income increases shareholder’s earnings per share (EPS). It’s an indication that the strategy carried out by a corporation was fruitful.
However, in case the strategy does not pan out as intended, it results in lower earnings compared to interest expense. Consequently, it causes a decrease in the shareholder’s income. That’s an indication of the unsuccessful implementation of the strategy.
Types of Trading on Equity
Trading on equity is also called financial leverage. Both these terms signify that a corporate body leverages its financial standing to procure debt and enhance the earnings of shareholders. In other words, a company utilises its equity strength to avail debts from creditors, and thus the name of the strategy.
Based on that understanding, there are two variants of trading on equity –
- Trading on thin equity
- Trading on thick equity
In the former case, a company borrows a sum that is more significant in comparison to its equity strength. In the latter case, a company acquires an amount that is modest in relation to its equity strength.
Effects of Trading on Equity
The primary effect of this financial strategy is a magnification of fluctuation in earnings before interest and taxes (EBIT) on a company’s EPS. The greater the share of debt in a company’s capital structure, the more significant is the variation in earnings per share in relation to the fluctuation in EBIT. But it also augments the risk posed to ordinary shareholders because of the uncertainty of its success.
Measuring the Effects of Trading on Equity
In order to measure the effects of trading on equity, there are two metrics that managers utilise –
- Capital Gearing Ratio = (Preference capital + Debentures) / Shareholder’s equity
- Degree of financial leverage = % change in EPS / % change in EBIT
By means of capital gearing ratio, one can understand the degree to which a company’s capitalisation depends on its equity. By means of the degree of financial leverage, one can comprehend how EPS shall fluctuate with respect to change in EBIT.
One shall understand that procuring debt is not the only way to increase a company’s income and produce more value for shareholders. It can be brought about by issuing ordinary shares as well or both. In fact, according to a popular theory, a company is successfully trading on equity when it utilises both debt capital and equity capital to finance its operations.
In any case, it is upon managers of a company to judiciously decide on alternative financing options. This can include solely issuing ordinary shares, solely borrowing, or striking a balance between issuance of shares and procurement of debt. What is paramount in this decision is that the cost of capital remains within the levels of reasonable risk to a company.
Since it is a complex concept, let’s understand trading on equity with the help of an example.
Reckon Limited wishes to finance an expansion. Its current capital structure consists of Rs.4 lakh as equity capital (Rs.10 per share). It requires another Rs.4 lakh to finance this expansion. For that purpose, managers of Reckon Limited are considering the following options –
- Issuance of ordinary shares worth Rs. 4 lakhs.
- Issuance of ordinary shares worth Rs.2 lakhs and the rest by procurement of 5% debt.
- Entire amount by procurement of 6% debt.
- Issuance of common stocks worth Rs.2 lakhs and the rest by issuing 5% preference shares.
The company expects to record an EBIT of Rs.240000 from its expansion venture.
|Particulars||Option 1||Option 2||Option 3||Option 4|
|EBIT||Rs. 240000||Rs. 240000||Rs. 240000||Rs. 240000|
|Less: Interest||Nil||Rs. 10,000||Rs. 24000||Nil|
|EBT||Rs. 240000||Rs. 230000||Rs. 216000||Rs. 240000|
|Less: Taxes @ 50%||Rs. 120000||Rs. 115000||Rs. 108000||Rs. 120000|
|Earnings After Taxes (EAT)||Rs. 120000||Rs. 115000||Rs. 108000||Rs. 120000|
|Less: Dividend to preference shareholders||Nil||Nil||Nil||Rs. 10000|
|Earnings available to shareholders||Rs. 120000||Rs. 115000||Rs. 108000||Rs. 110000|
|Number of shareholders||80,000||60,000||40,000||60,000|
|EPS||Rs. 1.5||Rs. 1.92||Rs. 2.7||Rs. 1.83|
From the above calculation, it can be seen that Reckon limited would be able to enhance the earnings of shareholders by opting for a pure debt approach.
Advantages of Trading on Equity
The two primary advantages of trading on equity are –
- Tax factor
One of the reasons why debt capital is a preferred source of financing for corporations is the factor of taxation. Since interest on the debt is an expenditure that is accounted for before the deduction of tax, it reduces a company’s overall tax liability. As can be seen in the example mentioned above, in both Option 2 and Option 3, the tax liability is lower compared to Option 1 & 4. This is where the magnification of fluctuation in EBIT begins.
- Debt-servicing cost
Another critical advantage of trading on equity is the lower debt-servicing factor. For instance, if a company procures 10% debentures and 10% preference shares, it would have to earn a pre-tax income of Rs.10 per Rs.100 to service the debt, but Rs.20 per Rs.100 to service the preference share. By virtue of that, trading on equity is more beneficial to enhance shareholder’s value.
Disadvantages of Trading on Equity
One critical disadvantage of trading on equity is the uncertainty of whether a business will be able to service debt. If the borrowed amount and overall cost of capital are not down to the level of reasonable risk a company can digest, then trading on equity can prove disadvantageous.
Furthermore, in case of interest rates go up in the course of servicing debt, it can suddenly increase the interest burden on its financial standing. In such situations, a company could be potentially staring at bankruptcy or immense loss.
Difference between Trading on Equity and Equity Trading
Often individuals confuse between the terms trading on equity and equity trading. However, these two terms convey supremely different concepts. While trading on equity is a financial strategy to enhance shareholder’s earnings, buying and selling of stocks is what equity trading is all about.
Managers of companies undertake and execute trading on equity; whereas, equity trading can be undertaken by any individual or entity. Via trading on equity, managers seek to gain from the difference between returns on investments and interest on debts.
On the other hand, via offline or online equity trading investors seek to capitalize on the share price changes by buying stocks at a discount and selling stocks at a premium.
It is thus imperative to be informed about the differences and the meaning of each of these concepts to do away with any prevailing confusion.