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Trading On Equity Meaning, Advantages, and Potential Risks

Trading on equity describes a process of making a profit for shareholders from a company’s debt. Trading on equity meaning refers to a situation when a business used bonds, preferred stocks, and other financial instruments to incur debt. Raised funds are utilized to receive bigger assets that cover the difference between the initial value and the interest rate making it possible for the company to create additional returns for shareholders.

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What’s more, the process can also help to increase earnings per share. Today, we are going to define the meaning of trading on equity as well as what main advantages and potential risks it may have for investors.

What Is Trading on Equity?

The term “trading on equity” is the process of providing a loan by the creditor to a company based on its equity strength. If the borrowed sum is larger, it can be described as trading on thin equity. If the borrowed funds are modest, experts call it trading on thick equity. As a rule, companies are provided with the most favorable terms to make the most of their equity.

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Trading on Equity Advantages

The process brings several crucial advantages for both company and shareholders”

  1. Enhanced earning. Trading on equity makes it possible for the business to gain a disproportional amount of funds on the asset.
  2. Favorable tax/interest rates. As a result, the expense, companies get with the interest rate, is tax-deductible, which means lower net costs for the borrower.

Trading on Equity Disadvantages

Together with disproportional gains, trading on equity can come with disproportional losses. If the borrower fails to earn a sufficient amount for return, it will be inevitably overwhelmed by the interest expense having not enough resources to offset it.

The situation can come with even greater risks in case a company uses short-term borrowing as the only way to provide funds for its operations. The key disadvantage here is related to short-term interest rate spikes, which may also be overwhelming for the borrower and result in immediate losses.

Besides, shareholders also have specific risks in case the cash flow falls resulting in outsized returns and, eventually, bankruptcy.

When Trading on Equity is Considered a Success?

The best way to ensure safe and stable profit when trading on equity is to follow several baseline points:

  1. You need to opt for a company with a non-speculative nature.
  2. A company is supposed to have stable and regular sales and profits.
  3. Once a well-established company has announced to implement these particular financing tools.

Lower debt-servicing factors, favorable interest expenses, and enhanced earning possibilities are among the major advantages of trading on equity. On the other hand, it can be quite risky for both investors and companies in case of not following basic principles.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.