Trading on Equity

Introduction
• Entire capital won’t be raised by issuing Equity Share Capital. • External sources of funds may be used. • Its proportion ranges from 40 to 70 percent. • It’s found profitable if such funds raised at a lower rate of interest. • Dividend can be paid at higher rate on equity shares, is known as “Trading on Equity”.

Meaning of Trading on Equity
• When a co. uses fixed interest bearing capital along with owned capital in raising finance, is said “Trading on Equity”. (Owned Capital = Equity Share Capital + Free Reserves ) • Trading on equity represents an arrangement under which a company uses funds carrying fixed interest or dividend in such a way as to increase the rate of return on equity shares.

Contd.
• It is possible to raise the rate of dividend on equity capital only when the rate of interest on fixed – interest – bearing – security is less than the rate of return earned in business. • Two other terms: • Trading on Thick Equity :- When borrowed capital is less than owned capital • Trading on Thin Equity :- When borrowed capital is more than owned capital, it is called Trading on Equity.

Definition
• Gerstenberg: “ When a person or a corporation uses borrowed capital as well as owned capital in the regular conduct of its business, he or she is said to be Trading on equity.” • Guthmann and Dougall: “The use of borrowed funds or preferred stock for financing, is known as trading on equity”

Contd.
• Hastings: “The degree to which debt is used in acquiring assets is called Trading on Equity.”

Conditions of success
• The rate of interest on borrowed capital must be lower than the rate of earnings on owned capital. • If the capital can be borrowed only on the security of assets, assets of the company will gradually be reduced with every increase in borrowed capital. Trading on equity will weaken the borrowing capacity of the company.

Contd.
• Trading on Equity can be used only when company’s earnings are stable and certain .

Limitations
• When the rate of interest on borrowed capital is less than the rate of return being earned by the company. • It will reduce the borrowing capacity of the co. as assets are required to place as security. • Income is more or less fixed are able to bear the burden of fixed interest charge.

Contd.
• Low proportion of Fixed Assets, have limited scope of trading on equity. • Legal restrictions on the amount to be borrowed. e.g. it can be borrowed up to the total amount of paid up share capital and free reserves only.

Contd.
• The Declining trend of profitability of business also limits the use of trading on equity. • Attitude of management restricts the use of trading on equity. • The nature of company’s business may also restrict the use of trading on equity.

Useful Suggestions
• The rate of dividend on equity share is calculated.: • Rate of Dividend = Distributable Profit*100 Equity Share Capital • If the rate of dividend is not given assumed @ 50% • Adjustment regarding transfer to General Reserve will be given.

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