Trading on Equity

Trading on equity is a financial strategy in which a company uses borrowed or fixed-cost funds to try to increase the earnings available to equity shareholders. It is also known as financial leverage.

• The return earned must be higher than the interest or fixed financing cost.
• In thin equity, a company may have equity of ₹250 crore and debt of ₹600 crore.
• In thick equity, a company may have equity of ₹700 crore and debt of ₹100 crore.
• Successful investments may improve returns for equity shareholders.
• Interest and repayment obligations continue even when the company earns less than expected.
• Higher borrowing can increase both the company’s potential returns and its financial risk.
   

Trading on equity is a corporate finance strategy in which a company uses debt or other funds carrying fixed financial costs to finance its activities and potentially increase its return on equity.
The company may use money raised through loans, debentures or preference shares for expansion, acquisitions or other business projects. The aim is to earn a return higher than the cost of these funds.
For example, suppose a company borrows money at an annual interest rate of 9% and invests it in a project that earns 15%. The difference may increase the earnings available to equity shareholders and improve the company’s return on equity.
However, the strategy works in the opposite direction when the project earns less than the financing cost. The company must still pay interest or other fixed charges, which may reduce shareholder earnings and lower its return on equity.
 

There are two main types of trading on equity. They are based on the proportion of debt and equity in a company’s capital structure.

1. Trading on thin equity

Trading on thin equity occurs when a company’s debt is close to or higher than its equity capital.

For example, a company with equity of ₹250 crore and debt of ₹600 crore depends heavily on borrowed funds. This may increase potential shareholder returns when the business performs well.

However, it also increases financial risk. The company must meet larger interest and repayment obligations even if its earnings decline.

2. Trading on thick equity

Trading on thick equity occurs when a company’s equity capital is much higher than its debt capital.

For example, a company with equity of ₹700 crore and debt of ₹100 crore finances most of its activities using shareholders’ funds.

This structure generally involves lower fixed repayment pressure. However, the company also uses less financial leverage to increase shareholder returns.

Consider a hypothetical Company Z that takes a loan to finance a technology project.

Company Z pays ₹6.75 crore as interest but earns ₹15 crore from the project. After covering the interest cost, it has a surplus of ₹8.25 crore.

This surplus may increase the earnings available to equity shareholders. Therefore, the use of borrowed funds has produced a positive financial leverage effect in this example.

If the project had earned less than ₹6.75 crore, the borrowing would have reduced the earnings available to shareholders.

Trading on equity may offer the following benefits when the return from an investment exceeds its financing cost.

• Amplified shareholder returns

  
  

  Borrowed funds allow a company to invest more than it could using only its equity capital. When the investment earns more than the interest or fixed financing cost, the remaining profit may increase the return available to equity shareholders.

  
  

• Access to additional funds

  
  

  A company can use loans, debentures or other fixed-cost funds to finance expansion and other business activities. For example, a company that does not have enough internal funds for a new project may borrow the required amount instead of issuing additional equity shares.

  
  

• Possible tax benefit

  
  

  Interest paid on capital borrowed for business purposes may be allowed as a deduction, subject to the applicable provisions and conditions of the Income-tax Act. This can reduce the company’s taxable business income.

  
  
  

Trading on equity can increase shareholder returns, but it also increases the company’s financial obligations.

• Financial risk

  
  

  Interest and loan repayments are fixed obligations. A company must make these payments even if its revenue or profit falls. If a debt-funded project does not produce the expected return, the company may struggle to meet its obligations.

  
  

• Changes in interest rates

  
  

  A rise in interest rates can increase the cost of borrowing, especially when the company has loans with variable interest rates. For example, a project may initially earn more than the loan’s interest cost. If the interest rate rises, the difference between the project return and borrowing cost may become smaller.

  
  

• Uncertain business conditions

  
  

  A company with unstable or unpredictable earnings may face greater risk when it depends heavily on debt. During a business downturn, lower earnings combined with fixed interest payments may put pressure on its finances.

  
  

• Higher losses

  
  

  Financial leverage can increase both gains and losses. When an investment performs well, shareholders may receive higher returns. When it performs poorly, fixed financing costs can make the decline in shareholder earnings larger.

  
  
  

Although the terms sound similar, trading on equity and equity trading are different financial concepts.

Trading on equity is a corporate finance strategy. A company borrows funds and invests them in business activities expected to earn more than the cost of borrowing.

Equity trading means buying and selling shares of listed companies. Investors generally aim to benefit from changes in share prices or earn income through dividends.

In simple terms, trading on equity is related to how a company finances its operations. Equity trading is related to how investors trade shares in the stock market.

Shareholders should examine both the potential benefits and risks when a company uses financial leverage.

• Possible earnings growth

  
  

  Successful debt-funded investments may increase the company’s earnings. This may support higher earnings per share and dividends, depending on the company’s performance and dividend policy. However, borrowing itself does not guarantee higher earnings or dividends.

  
  

• Greater financial risk

  
  

  A high level of debt means the company has larger interest and repayment obligations. Investors should check whether the company earns enough from its operations to meet these obligations. Weak debt-servicing ability may indicate greater financial risk.

  
  

• Effect on long-term stability

  
  

  Excessive borrowing can affect a company’s long-term financial position. Investors should consider whether the company’s earnings are stable enough to cover interest and repayments during both favourable and difficult business periods.

  
  

• Need for a balanced assessment

  
  

  Debt should not be considered separately from the company’s profitability, cash flow and business conditions. For example, the same debt level may be manageable for a company with stable cash flows but risky for a company with uncertain earnings.

Read more: What is National Stock Exchange 

Trading on equity allows a company to use borrowed or fixed-cost funds to increase the earnings available to equity shareholders. It can work when the return from an investment is higher than the financing cost.
However, interest and repayment obligations remain even when the company’s earnings decline. Companies should therefore maintain a suitable balance between debt and equity. Investors should also examine the company’s earnings, cash flows and repayment capacity before assessing the possible effect of financial leverage.