Read this article to learn about Trading on Equity:- 1. Meaning of Trading on Equity 2. Determinants of Trading on Equity 3. Limitations.
Trading on equity refers to the practice of using borrowed money at fixed interest rates or issuing preference shares with constant dividend rates in the hope of obtaining a higher rate of return on the money used than the interest or preferred dividends paid.
Trading on equity means taking advantages of ownership. Here ownership means equity (capital) and trading means taking advantage of a company is mainly interested in two aspects of its capital, viz:
(1) The funds invested by (equity) shareholders, i.e., equity share capital, and
(2) Free reserve (set aside mainly for reinvestment purposes).
In every country there are statutory rules relating to a company’s composition of capital. The debt-equity ratio of a company is determined by the government through suitable Acts, such as the Companies Act passed by the Government of India in 1956.
In order to be able to raise financial resources by selling bonds or debentures, a company will have to have a minimum amount of owners’ (equity) capital. In other words, only on the strength of its equity (or ownership) capital, a company can raise finance from outsiders.
External capital usually takes the following three forms:
(1) Loans — short term, or long-term or even public deposits,
(2) Debentures and
(3) Preference shares.
These three sources of external capital go by the name ‘rentier capital’ on which the company is required to pay rent or fixed interest either in the form of fixed dividends or fixed interest. Financing a company’s business (investment activities) through such rentier capital is technically called ‘trading on the equity’.
The term is used to mean that a company has financed the purchase (acquisition) of its fixed (as opposed to current) assets through the sale or issue of limited fixed interest (dividend) bearing assets. In short, when a company (corporation) uses loan capital as well as owned capital in the regular conduct of the business, it is said to be trading on the equity.
Let us consider the example of Table 3.4.
In this example A Co. did not rely on trading on the equity method. And it was in a position to declare 15% dividend on Rs 400 lakhs of equity capital. By contrast, B Co. did take resort to trading on the equity by issue of 15% interest bearing rights issue of debenture capital worth Rs 200 lakhs. Therefore, the company was in a position to declare 22.5% dividend on its equity (share) capital worth Rs 200 lakhs.
It is quite clear that when the corporate tax rate is 50% of profits, A Co. had to make 30% profits in order to pay dividend at the rate of 15% on shares. Instead the company could sell debentures or attract public deposits of the same amount and still pay 15% interest without any tax. It is so because interest paid on bonds and debentures is a deductible expense for tax purposes.
This simple example makes one thing clear at least. The fiscal system makes bond financing cheaper than equity financing. In other words, the cost of debt (loan) capital to a company is low due to favourable tax treatment (due to the fact that interest on debt is a deductible expense for tax purposes) whereas the cost of equity (risk) capital is disproportionately high (i.e., due to the fact that corporate dividend is subject to corporate income tax.
In our illustration, since the tax rate is 50%, corporate tax saving on Rs 30 lakhs interest is Rs 15 lakhs. This tax relief gives a profit figure of Rs 45 lakhs (compared to Rs 60 lakhs in case of A Co.). This raises the equity dividend from 15% to 22.5%. This very fact provides the real justification of trading on equity, i.e., to attract public deposits or to take loans from the public, make tax saving and thus, ultimately, push up the dividend rate.
Just as a company’s gain can be magnified when trading on equity so can its losses. It is also known as leverage. It refers to the advantage (or disadvantage) obtained by the use of borrowed funds; the effect of trading on equity is the use of senior capital in capitalisation (i.e., a security that has a prior claim on assets and/or income in the form of borrowed funds, bonds, or preference shares, ranking ahead of junior equity, operating leverage being provided by having relatively fixed operating expenses, relating to expanding or contracting sales or revenues, or by invested assets and earnings assets or deposits being made available relative to shareholders’ equity or book value. There are several limitations on trading on equity.
The following points may be noted in this context:
Firstly, in order to be able to pay handsome dividends and attract share capital, a company must earn more than what it has to pay as interest on bonds (debentures) or fixed dividend on preference shares. In our example, if profit is Rs 30 lakhs instead of Rs 120 lakhs, i.e., a modest 7% return on net investment, hardly anything will be left over for distribution among shareholders as dividends.
In this context, the entire profit of Rs 30 lakhs will have to be utilised for interest payment.
Secondly, trading on equity carries good sense only when proper allowance is made for fluctuations in earnings. If a company is to make any real gain from trading on equity its ratio of net income to fixed charges has to be greater than 2:1 ratio. Since during a deep depression or a prolonged recession a company is likely to face considerable financial difficulties, it is in the Tightness of things to maintain a safe ratio.
In the financial literature this is called the safety factor, which ensures the payment of fixed charges, i.e., interest on debentures and dividend on preference shares even though profits have dropped down by 50% (i.e., profits have been halved). In our example, since the ratio of net profit to fixed charges is 3: 2, the company is in a position to pay interest even though profit falls from Rs 60 lakhs to Rs 30 lakhs. It should not be missed that both profits and losses get inflated due to trading on equity.
Thirdly, trading on equity is profitable only under the following circumstances:
(i) When a company is a well-established one,
(ii) When a company is engaged in non-speculative business and
(iii) When sales volume and earnings (profits) of a company are more or less stable, regular and fairly certain.
In reality, we observe that when a company is well-established, as is the case with public utility concerns, trading on equity are found to be profitable.
Since such companies have maximum liquidity, they can undertake the risk of borrowing on a large scale and paying a huge sum in the form of interest and fixed dividends. Such companies may have equity capital of about 40% and debt capital of 60% in their capital structure.
However, in most manufacturing enterprises and commercial concerns we find modest trading on equity. In such companies borrowed funds may constitute even less than 40% due to lack of sufficient liquidity which is attributable to fluctuating sales, changing profits and, above all, narrow profit margins.
Trading on equity also suffers from diminishing returns. In fact, any increase in borrowing will raise the rate of interest in an imperfectly competitive capital market. This means that further borrowing will be more and more costly.
To adopt this practice an enterprise will have to make a huge investment in fixed assets just to make its creditors (the lenders of funds) feel safe and secure.