Trading on Equity
Trading on Equity
refers to the practice of using borrowed funds, carrying a fixed charge, to
obtain a higher return to the Equity Shareholders. With a larger proportion of
the debt in the financial structure, the earnings, available to the owners
would increase more than the proportionately with an increase in the operating
profits of the firm. This is because the
debt carries a fixed rate of return and if the firm is able to earn, on the
borrowed funds, a rate higher than the fixed charges on loans, the benefit will
go the shareholders. This is referred to as “Trading on Equity”
The concept of
trading on equity is the financial process of using debt to produce gain for
the residual owners or the equity shareholders. The term owes its name also to
the fact that the equity supplied by the owners, when the amount of borrowing
is relatively large in relation to capital stock, a company is said to be
trading on equity, but where borrowing is comparatively small in relation to
capital stock, the company is said to be trading on thick equity. Capital
gearing ration can be used to judge as to whether the company is trading on
thin or thick equity.
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