What is Trading on Equity: Types & Advantages

Trading on equity, also known as financial leverage, is a strategy where companies use borrowed funds to boost returns for equity shareholders. By utilising debts like bonds, loans, or debentures, companies aim to acquire assets or invest in projects that can generate returns profits higher than the cost of borrowing. This article explores the concept, its types, advantages, and implications for both companies and investors.

What is Trading on Equity?

Trading on equity means leveraging the company’s equity strength to secure debt, using the borrowed funds to potentially generate higher returns than the cost of the debt. If implemented successfully, this approach increases shareholders’ earnings per share (EPS). However, it carries risks if the returns are lower than the borrowing cost.

For example, A company borrows ₹10 crores at a 10% interest rate to purchase a factory. If the factory generates ₹15 crores in revenue, the extra ₹5 crores enhances shareholder returns.

Trading on Equity Example

To understand the concept of trading on equity in more detail, let us take up an easy to understand example. Suppose there is an individual investor, Priya, who is interested in investing in the shares of a technology company. Priya decides to invest in a technology company named “ABC Solutions.”

Priya has an initial capital of ₹7,50,000. To amplify her returns, she borrows an additional ₹4,50,000 from a bank, and the borrowed funds’ interest rate is 9% per annum. This brings her total investment in ABC Solutions to ₹12,00,000. This scenario allows us to examine how different potential returns on Priya’s total investment would impact her overall profit and her return on her initial equity (her own capital). The ratio of borrowed funds to Priya’s capital is 0.6 (₹7,50,000/ ₹4,50,000), which indicates the level of leverage she issuing, similar to a company’s debt-to-equity ratio.

The following table will show the impact of trading on equity for Priya under three different scenarios of assumed return on her total investment:

In Scenario 1: If Priya’s total investment of ₹12,00,000 yields a return of 6%, she would earn ₹72,000. However, she has to pay an interest of ₹40,500 on the borrowed funds (9% of ₹4,50,000). This leaves her with a profit of ₹31,500. Her return on her initial capital of ₹7,50,000 is therefore (31,500 / 7,50,000) * 100 = 4.2%. In this case, where the return on the total investment (6%) is less than the cost of borrowing (9%), the use of leverage has negatively impacted Priya’s return on equity compared to the 6% return she would have achieved if she had invested only her own capital.

In Scenario 2: If the total investment yields an 11% return, Priya would earn ₹1,32,000. After paying the interest of ₹40,500, her profit would be ₹91,500. The return on her initial capital would be (91,500 / 7,50,000) * 100 = 12.2%. Here, because the return on the total investment (11%) is greater than the cost of borrowing (9%), leverage has positively amplified Priya’s return on equity to 12.2%, which is higher than the 11% return she would have made without borrowing.

In Scenario 3: With a 16% return on the total investment, Priya would earn ₹1,92,000. After deducting the interest of ₹40,500, her profit would be ₹1,51,500. Her return on equity would be (1,51,500 / 7,50,000) * 100 = 20.2%. This scenario further illustrates the magnifying effect of leverage when the investment performs well. The return on equity of 20.2% is significantly higher than the 16% return on the total investment.

This example clearly shows how trading on equity is a double-edged sword that can magnify returns when investments are profitable, as seen in Scenarios 2 and 3. However, it also highlights the risk, as shown in Scenario 1, where leverage can amplify losses or reduce returns if the investment performance is insufficient to cover the borrowing costs. The key factor determining whether trading on equity is beneficial is the difference between the return on the total investment and the interest rate on the borrowed funds.

What is the Purpose of Trading on Equity?

The primary goal of trading on equity is to enhance shareholder wealth while keeping the cost of financing low. Companies use this strategy when they:

• Seek to maintain control by avoiding equity dilution.
• Need to finance large-scale projects or expansions.
• Aim to maximise profits for existing shareholders by leveraging debt capital.

Types of Trading on Equity

Trading on equity can be classified into two main types based on the company’s capital structure:

1. Trading on Thin Equity

Trading on thin equity occurs when a company’s debt capital is significantly higher than its equity capital. This strategy relies heavily on borrowed funds to finance operations and expansion.

• Characteristics:
  • High financial leverage and risk.
  • Greater dependence on consistent revenue to cover interest obligations.
  • Often used by companies in industries requiring significant capital investment (e.g., infrastructure).
• Example: A company has ₹50 crores in equity capital and ₹150 crores in debt. This capital structure represents trading on thin equity, as the debt is three times the equity capital.

2. Trading on Thick Equity

Trading on thick equity occurs when a company uses a greater proportion of equity capital than its debt capital. This approach reduces financial risk but also limits potential returns on equity.

• Characteristics:
  • Lower financial risk due to reduced reliance on debt.
  • More suitable for companies in stable or mature industries with limited growth prospects.
  • Retains greater financial flexibility.
• Example: A company has ₹200 crores in equity capital and ₹50 crores in debt. This structure represents trading on thick equity, as the equity capital far exceeds the borrowed capital.

What are the Implications of Trading on Equity on an Investor?

Trading on equity has direct implications for investors, as it affects their potential returns, risks, and confidence in the company. Let’s analyse these implications further:

1. Increased Returns on Equity

One primary benefit of trading on equity is the potential for higher Earnings Per Share (EPS) when a company successfully uses borrowed funds to generate returns greater than the cost of debt. For investors, this translates into better dividends and capital gains.

• Example: A company borrows ₹10 crores at a 10% interest rate to expand operations, earning ₹15 crores in additional revenue. After deducting ₹1 crore in interest, the remaining ₹14 crores enhance the returns for shareholders.

2. Increased Risk Exposure

While trading on equity can amplify returns, it also increases financial risk. If a company’s returns on investment fall below the cost of debt, it reduces shareholder earnings.

• Scenario: Suppose a company borrows ₹10 crores at a 10% interest rate, but its expansion project only generates ₹8 crores. The shortfall reduces equity earnings, negatively affecting investor returns.

3. Dividend Volatility

Higher debt obligations mean that a company must prioritise interest payments over dividends. During periods of low revenue, this may result in reduced or skipped dividend payouts, which can impact investor income.

4. Share Price Sensitivity

Companies with high leverage often face greater scrutiny in financial markets. Any adverse financial performance or economic downturn can lead to sharper declines in share prices, impacting investors holding such stocks.

5. Impact on Confidence

Investors often associate high debt levels with increased risk. While leverage can enhance growth, excessive reliance on debt may erode investor confidence and deter new investments.

Advantages of Trading on Equity

This strategy offers several benefits:

1. Enhanced Earnings: Borrowed funds allow companies to invest in revenue-generating assets, which boosts EPS.
   • Example: A company borrows ₹5 crores to expand operations, generating ₹8 crores in additional revenue.
2. Tax Benefits:
   • Interest on debt is tax-deductible, reducing the company’s overall tax liability.
   • Example: If a company pays ₹1 crore in interest on debt, this amount is deducted before calculating taxable income.
3. Control Retention:
   • Unlike equity financing, debt does not dilute ownership or voting rights.

Challenges of Trading in Equity

While trading on equity has its advantages, it also comes with drawbacks. Here are a few disadvantages of trading on equity:

1. Financial Burden:
   • Companies must pay interest on debt regardless of profitability.
   • A downturn in revenue can strain resources, leading to potential bankruptcy.
2. Market Volatility:
   • Increases in interest rates or economic downturns can exacerbate financial challenges.
   • Example: A sudden rise in interest rates can increase the cost of servicing debt.
3. Risk of Over-Leverage:
   • Excessive reliance on debt can erode shareholder confidence and impact the company’s credit rating.

What is the Difference Between Trading on Equity and Equity Trading?

Although trading on equity and equity trading may sound similar, they are entirely different concepts in financial management and stock market operations.

Here’s a detailed comparison:

Conclusion

Trading on equity is a powerful financial strategy to boost shareholder returns, particularly for companies confident in generating higher revenues than the cost of borrowing. While the approach offers benefits like tax savings and enhanced EPS, it also requires careful management to mitigate risks like over-leverage and financial instability.

Understanding what is trading on equity, its types, and its advantages can help investors and managers make informed decisions. However, the key lies in balancing debt and equity to ensure sustainable growth.

Disclaimer: This content is only for educational/ informational purposes. It does not make any recommendation to act or invest.