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.
Types of trading on equity
There are two main types of trading on equity that highlight the balance between debt and equity in a company’s capital structure.
1. Trading on thin equity
This occurs when a company’s debt capital is nearly equal to, or higher than, its equity capital. In such cases, the business relies heavily on borrowed funds, increasing its leverage and potential financial risk. For example, if a firm has equity of Rs. 250 crores and debt of Rs. 600 crores, it is considered to be trading on thin equity. The high dependence on external borrowing makes operations more vulnerable to repayment pressures.
2. Trading on thick equity
In contrast, trading on thick equity happens when equity capital significantly exceeds debt. Here, the company funds most activities through internal equity rather than loans. For instance, if equity stands at Rs. 700 crores and debt at Rs. 100 crores, the company shows financial strength with lower leverage and reduced risk exposure.
Example of trading on equity
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
- 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.
- 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.
- 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
- 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.
- 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.
- Market volatility: If the company's earnings are volatile or unpredictable, relying heavily on debt to finance investments can exacerbate financial instability during downturns.
Difference between trading on equity and equity trading
Although the terms trading on equity and equity trading may appear similar, they refer to entirely different financial concepts.
- Trading on Equity is a corporate finance strategy aimed at enhancing shareholders’ earnings by using debt. It involves a company borrowing funds and investing them in such a way that the return on investment exceeds the cost of borrowing. This difference between returns and interest payable leads to increased earnings for shareholders. The strategy is also referred to as financial leverage.
- Equity Trading, on the other hand, refers to the act of buying and selling shares of publicly listed companies. This activity is carried out by individual investors and institutions alike. The goal is to generate profits by capitalising on price fluctuations in the stock market – typically by purchasing shares at a lower price and selling them at a higher one.
In essence, trading on equity is a financial tactic used by companies, while equity trading is a market-based activity accessible to any investor.
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:
- 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.
- 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.
- 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.
Read more: What is National Stock Exchange
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.
