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Question
Explain the term trading on equity. Why, when and how can it be used by business organisations?
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Solution
Trading on equity is the financial process of using debt to produce gain for the residual owners. The practice is known as trading on equity because it is the equity shareholders who have only interest (or equity) in the business income.The term owes its name also to the fact that the creditors are willing to advance funds on the strength of the equity supplied by the owners. Trading feature here is simply one of taking advantage of the permanent stock investment to borrow funds on reasonable basis.
Trading on equity acts as a lever to magnify the influence of fluctuations in earnings. Any fluctuation in earnings before interest and taxes (EBIT) is magnified on the earnings per share (EPS) by operation of trading on equity larger the magnitude of debt in capital structure, the higher is the variation in EPS given any variation in EBIT.
Trading on equity is the financial process of using debt to produce gain for the residual owners. The practice is known as trading on equity because it is the equity shareholders who have only interest (or equity) in the business income.
The term owes its name also to the fact that the creditors are willing to advance funds on the strength of the equity supplied by the owners. Trading feature here is simply one of taking advantage of the permanent stock investment to borrow funds on reasonable basis.
Trading on equity acts as a lever to magnify the influence of fluctuations in earnings. Any fluctuation in earnings before interest and taxes (EBIT) is magnified on the earnings per share (EPS) by operation of trading on equity larger the magnitude of debt in capital structure, the higher is the variation in EPS given any variation in EBIT.
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