Trading on Equity: Meaning, Benefits & How It Impacts Returns

Companies use various financial strategies to boost the earnings of their equity shareholders, and one such strategy is trading on equity. It is a fundamental concept in the world of finance and investment. So, what is trading on equity? What are its benefits and how does it affect returns on investment? Let’s take a closer look.

What is trading on equity?

When a company uses debt capital to invest in assets that are expected to generate returns higher than the interest of the debt, it is called trading on equity. Also called financial leverage, we can define trading on equity as a strategy where a company leverages borrowed funds to magnify earnings for its equity shareholders.

If the strategy is successful, that is, if the returns exceed the interest payable on the debt, it results in an increase in earnings per share (EPS). However, if the strategy doesn’t yield the desired results, it leads to reduced earnings and the equity shareholders may have to bear the losses.

Types of trading on equity

Now that we know trading on equity meaning, let’s understand the types of trading on equity:

1. Trading on thin equity: When a company’s debt capital is greater than its equity capital, it is said to be trading on thin equity. For instance, if a company has debt capital of ₹500 crore and equity capital is ₹100 crore, it is considered to be trading on thin equity. In such cases, the company depends more on borrowed funds, leading to increased financial risk.

2. Trading on thick equity: Trading on thick equity occurs when a company’s equity capital is substantially higher than its debt capital. If a company’s equity is ₹500 crore and debt is only ₹100 crore, it is considered trading on thick equity. As the company relies more on internal funding, it reduces financial leverage and risk.

Benefits of trading on equity

Let’s take a look at some key benefits of trading on equity:

• Improved returns for shareholders: Trading on equity has the potential to generate higher returns for shareholders. If a company’s investment generates returns that are greater than the interest paid on debt, it increases profits and leads to higher earnings per share (EPS) for shareholders.

• Tax benefits: Trading on equity offers tax benefits. The interest on debt or borrowed funds is tax-deductible, hence, it reduces the borrowing company’s taxable income and overall tax liability. When the company pays lower tax, its net profits increase.

• Ownership control: One of the primary reasons why trading on equity is preferred is that the company gets to retain its control over its business. According to the trading on equity definition, when a company raises funds through debt rather than issuing additional equity shares, only a small group of existing shareholders retain voting power. This enables the original owners to exercise more power. Issuing more equity shares will dilute ownership and control of the company.

• Lower debt-servicing cost: Debt financing is often less expensive than equity. For example, if a company procures 10% debentures and 10% preference shares, it would have to earn a pre-tax income of ₹10 per ₹100 to service the debt, but ₹20 per ₹100 to service the preference share. By virtue of that, trading on equity is more beneficial to enhance shareholder’s value.

• Improves company goodwill: When a company gives higher returns to equity shareholders, it helps improve the company’s goodwill. This can attract more investors.

Disadvantages of trading on equity

Some of the risks involved in trading on equity are:

• Financial risk: The company can incur huge loss if it does not generate the expected returns. In other words, if the company fails to generate returns higher than the cost of borrowing, it can struggle to meet its debt obligations. The shareholders may also have to suffer.

• Market volatility: If a company’s earnings are unpredictable and it relies heavily on debt for financing investments, it can lead to financial instability when markets are volatile.

• Increase in interest rates: A company has to pay interest on the debt to the borrowers. Rise in interest rates can increase the company’s interest expenses on borrowed funds. As a result, the company can suffer immense loss and can even go bankrupt because the financial burden of the interest would increase.

• Impact on credit rating: If the company is found to have taken excessive debt, it can affect the company’s creditworthiness and also credit ratings.

How trading on equity impacts returns

The effect of trading on equity depends on the company’s ability to leverage borrowed funds to boost returns for equity shareholders. Here’s how trading on equity impacts returns:

• If the company’s investments are successful and it generates returns higher than the cost of debt, equity shareholders get magnified returns. To put it in simple words, if the company’s earnings exceed borrowed funds, it increases the net incomes of its shareholders and the market value of the shares also increases.

• If the company’s cost of debt is more than its earnings or returns from the borrowed funds, the earnings per share reduces, increasing the company’s financial risks.

• If there’s not much difference between earnings and debt capital raised, there will not be any change in returns of shareholders.

Conclusion

Trading on equity is an effective strategy that allows companies to strategically use debt capital to amplify returns for equity shareholders. However, while this practice can be highly profitable, it can also lead to significant losses. The key lies in optimising debt capital to strike the right balance between returns and risk. When managed wisely, it helps maximise earnings per share. At the same time, excessive debt can increase financial risk. So, it is vital to clearly understand trading on equity meaning along with trading on equity example to avoid any financial pitfalls.