Even though the name suggests that it is trading on equity, it is not remotely close to what we know as equity trade. It does not involve any kind of equity at all. Rather than that, it involves debt capital in the form of debentures, preference shares, bonds, and many others, which the organizations secure to provide funding for day-to-day activities.
Whether you are a seasoned trader or someone just getting started, it is a must-know for you to understand the fundamentals of trading on equity to better assess an organization's future growth and financial position. In this blog, we will take a look at what trading on equity is.
Basic understanding of trading on equity
Equity trading is a financial tactic where you or your organization may borrow money like loans or debts. You borrow the funds to invest in some things or run a business to generate more revenue and profit. Here, equity implies money you have put into your business or what the organization's shareholders own.
Types of trading on equity
Generally speaking, there are two kinds of trading on equity:
1. Trading on thin equity
It is when you utilize a short amount of your shareholders' equity or your money to support a massive amount of borrowed funds. It includes taking on a higher level of financial leverage where the borrowed money is way higher than the equity capital.
2. Trading on thick equity
Trading on thick equity implies utilizing a certain amount of your shareholders' equity or your own money to support a comparatively smaller amount of funds that have been borrowed. The focus here is maintaining a conservative capital structure with lower financial leverage.
The purpose of trading equity
A Trade on equity enables you to enhance the investment returns and assists a business in growing. Traders borrow the money to increase their potential profits on their primary investment. Additionally, it enables organizations to get extra funds to expand their operations or get started on new projects, which leads to growth and progress.
Effects of trading on equity
The meaning of trading on equity is pretty obvious. If you wish to measure the effects of equity trading, there are two metrics that the managers utilize:
- Capital gearing ratio= (Debentures Preference capital)/Shareholder's equity
- Degree of financial leverage= % change in EPS/ % change in EBIT
The capital gearing ratio provides insight into how much an organization's capitalization depends on its equity. The degree of financial leverage can be used to understand how EPS will change in response to changes in EBIT.
It is important to realize that raising debt is not the only strategy to boost a business's revenue and raise shareholder value. It may be achieved by issuing common shares as well. In fact, a common notion states that when a business uses debt and equity capital to fund its operations, it trades successfully on equity.
In any event, it is the responsibility of a company's managers to carefully consider alternate financing possibilities. This can involve borrowing exclusively, issuing only common shares, or balancing debt acquisition and share issues. Ensuring that the cost of capital stays within a company's reasonable risk threshold is crucial while making this selection.
Difference between equity trading and trading on equity
There are many instances when individuals confuse the terms of trading on equity and equity trading. However, these two terms are extensively different from one another. While open trade equity is a good financial tactic to enhance a shareholder's earnings, selling and purchasing stocks is what equity trading is all about.
Managers of organizations take on and execute trading on equity, whereas any entity or a person may undertake equity trading. With equity trading, the managers seek to obtain from the difference between investments and returns and interest on debts.
On the other hand, with online or offline equity trading, investors seek to capitalize on the price of share changes by purchasing stocks at a discount or selling those stocks at a premium.
Wrapping Up
So there you have it, a simple explanation of the basics of trading on equity. In a simple explanation, we can state that trading on equity is a great strategy for organizations to procure more funds to purchase new assets and use them to pay for their debt.
