Trading on Equity Explained

Trading on equity is the utilization of preferred stocks, bonds, and other debt for increasing common stock earnings. It signifies raising the cost fixed capital involving preference share and borrowed capital based upon equity share to achieve income generation for equity shareholders. However, it is important to remember that this kind of arrangements become possible only when return rates are higher than borrowed capital interest rates or preference share dividend rates.

EBIT or Operating Earnings signify business profits from which one needs to deduct the tax and interest payments. It is the index of the capabilities of a business to earn profits. Investors providing cost fixed capital have limited number of shares in the profit of the company. Resultantly, their main aim is to keep the investment safe with owners’ capital. After all, lenders will be offering loans to business only when it has a strong base with sufficient capital related to equity share.

This is quite natural, because lenders would always try to remain safe. In case if heavy losses due occur or if the business goes bankrupt, equity shareholder will suffer a big financial setback. Lender priority payment signifies safety of the loan amounts. You may ask, how will the earning of equity shareholder increase in cases where companies raise the borrowed capital? After deduction of tax and interest from EBIT whatever left constitutes EAIT or Earning after Tax (EAT).

This is because the payment of interest happens before the tax payments. If preference dividend is present, its deduction occurs from EAT and then whatever is left is the Earning Available related to trading on equity.