What is Trading on Equity

Trading on equity is the practice of using borrowed funds or debt to increase the potential return on equity.
What is Trading on Equity
3 mins
13 July 2024

Trading on equity is a fundamental concept in the world of finance and investment. It refers to the practice of using borrowed funds, typically in the form of debt, to increase the potential returns for the shareholders of a company. This strategy involves leveraging the company's equity or common stock to generate higher profits. As a common practice, the companies aim to invest in assets or projects using the borrowed funds, debentures, loans, or preference shares which will generate revenue that surpasses the cost of obtained funds.

In this article, we will delve into the intricacies of trading on equity, its benefits, risks, and implications for both companies and investors.

What is trading on equity?

At its core, trading on equity involves the use of debt capital to finance investments or projects that are expected to yield returns greater than the cost of the borrowed funds. In simpler terms, it is a strategy that allows a company to magnify its earnings by investing in projects that have the potential to generate higher profits than the interest expenses on the debt.

This concept is most seen in the corporate world when companies decide to take on debt to fund expansion, acquisition, or other business activities that are expected to increase their earnings. By doing so, they aim to achieve an "equity multiplier" effect, where the return on equity (ROE) is greater than the cost of debt.

Trading on equity example

Consider Company Z in the Indian stock market. They took a loan of Rs. 75 crore with a 9% interest rate. Using this money, they invested in shares of a promising technology company listed on the stock exchange. The interest paid on the loan was Rs. 6.75 crores, and the value of the technology company's shares increased, resulting in a gain of Rs. 15 crores.

In this situation, Company Z successfully used the trading on equity strategy in the Indian stock market. They borrowed money to invest in stocks, not only covering the interest expenses but also making significant profits. This showcases the effectiveness of the trading on equity approach.

Benefits of trading on equity

  1. Amplified returns: The primary advantage of trading on equity is the potential to generate higher returns for shareholders. If the company's investments yield profits greater than the interest expenses on the debt, shareholders benefit from the increased earnings.
  2. Leverage: Trading on equity allows a company to leverage its existing equity base to access additional funds. This can be particularly useful for growth-oriented companies that may have limited internal resources for expansion.
  3. Tax shield: Interest payments on debt are often tax-deductible, providing a tax shield that reduces the overall tax liability of the company. This can further enhance the company's net income.

Risks and considerations

  1. Financial risk: While trading on equity has the potential for higher returns, it also exposes the company to increased financial risk. If the investments financed by debt do not yield the expected returns, the company could struggle to meet its debt obligations, leading to financial distress.
  2. Interest rates: Fluctuations in interest rates can significantly impact the cost of debt. A rise in interest rates could increase the company's interest expenses, potentially eroding the benefits of trading on equity.
  3. Market volatility: If the company's earnings are volatile or unpredictable, relying heavily on debt to finance investments can exacerbate financial instability during downturns.

What is the difference between trading on equity and equity trading?

"Trading on equity" typically denotes a company's use of financial leverage, where it borrows funds to finance its operations or investments. The focus is on the financial structure, emphasising the relationship between equity and debt. On the other hand, "equity trading" pertains to the buying and selling of company stocks in the financial markets. It involves investors and traders engaging in transactions to profit from price fluctuations in equities. While both involve the realm of equity, the former deals with a company's capital structure and financial strategy, while the latter revolves around the dynamic activity of buying and selling stocks in the market.

Implications for investors

Investors, particularly shareholders, should closely monitor a company's decision to trade on equity. While this strategy has the potential for higher returns, it also comes with increased risk. Here are a few implications for investors:

  1. Earnings growth: Trading on equity could lead to accelerated earnings growth if the investments financed by debt are successful. This could positively impact stock prices and dividends.
  2. Risk assessment: Investors need to assess the company's ability to manage the additional debt burden. High levels of debt could indicate a higher degree of financial risk.
  3. Long-term viability: A company's long-term viability could be affected if it becomes over leveraged. Investors should consider whether the company's earnings can consistently cover its debt obligations.

Types of trading on equity

There are different types of trading on equity, often classified based on the methods and instruments used. Here are the main types:

Trading on thin equity

Trading on thin equity refers to a scenario in which a company's borrowed funds or debt capital are notably closer in value to its equity capital. This indicates that the company's level of debt is relatively high compared to its equity. In other words, the company's total liabilities, represented by its debt capital, are substantial in relation to the value of its ownership, represented by its equity capital.

For instance, if Company ABC has an equity capital of Rs. 250 crores while its debt capital amounts to Rs. 600 crores, the company is considered to be trading on thin equity. This situation suggests that a significant portion of the company's operational activities and investments are funded through borrowed funds, which could potentially expose it to higher financial risk due to its elevated leverage.

Trading on thick equity

Conversely, trading on thick equity refers to a situation where a company borrows a relatively smaller amount compared to its equity capital. This implies that the company's equity is substantially higher than its debt obligations. In simpler terms, the company relies more on its internal funding sources (equity) rather than external borrowing (debt).

For example, if Company XYZ has an equity capital of Rs. 700 crores and a debt capital of Rs. 100 crores, the company is said to be trading on thick equity. This suggests that the company enjoys a robust financial position since it possesses a significant ownership stake in its operations. As a result, the company's financial leverage is lower, potentially leading to reduced financial risk.

Conclusion

Trading on equity is a financial strategy that allows companies to potentially amplify their returns by using borrowed funds to finance investments. While it can lead to increased profits and higher returns for shareholders, it may also come with greater financial risk. Investors and companies alike should carefully weigh the benefits and risks before implementing this strategy. As with any financial decision, a thorough understanding of the company's financial health and market conditions is essential to make informed choices regarding trading on equity.

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Frequently asked questions

What is trading on equity?

Trading on equity, also known as financial leverage, involves utilising fixed-cost sources of finance such as preference shares, debentures, and long-term loans within the capital structure to enhance the returns on equity shares.

When do we use trading on equity?

Trading on equity is employed when the company wants more finance from debt sources rather than equity. The company uses this strategy to ensure that control over the company remains the same. A company might also use the trading on equity strategy to increase the company’s market share price.

Is the strategy of trading on equity safe to employ by a company?

Trading on equity involves risks and is not always safe to employ by a company. The company must ensure that the returns generated from the assets purchased using the borrowed funds are higher than the interest paid on the debt. If the company fails to generate sufficient returns, it may face financial difficulties and may not be able to pay back the debt.