Explain the term ‘Trading on Equity’. Why, when and how it can be used by a company?

Trading on equity is the financial process of using debt (borrowed capital) to produce gain for the remaining owners. It is practiced because the equity shareholders have interest only in the business income.

The term trading on equity means that the creditors are willing to give loans on the strength of equity supplied by the owners which means if sufficient portion of equity is available then only the debts can be raised.

When the amount of borrowing is more than capital stock a company is said to be trading on equity but where the borrowed capital is comparatively small the company is said to be trading on thick equity.

The fluctuations in EBIT can be magnified on EPS by operating on trading on equity.

Impact on trading on equity can be explained with the help of following example –

The capital structure of P Limited is 10000 equity shares of Rs 100 each. The management wishes to raise another 10 lakh to finance a major project for which it has following four options -

A. All by equity issue

B. Rs 5 lakh by equity shares and Rs 5 lakh by 5% Debentures

The present EBIT is Rs 120000 and tax rate is 50%

The EPS of Option B his higher than Option A, because the company has taken benefit of trading on equity.