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What is Trading on Equity

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Trading on equity refers to the practice where a company uses its fixed interest-bearing securities, such as bonds or debentures, to raise additional capital. This allows the company to leverage its equity base and enhance the potential returns for equity shareholders. The essence of trading on equity is utilizing debt to increase profits and provide a higher return on shareholders’ funds. Companies use this strategy when they are confident that the returns from the borrowed capital will exceed the cost of interest.

By employing trading on equity, businesses can amplify their earnings per share (EPS), provided they achieve a higher return on investments than the cost of borrowing. However, if a company is unable to generate sufficient returns, it risks facing financial stress due to interest obligations. Hence, it's essential to evaluate the risk before adopting this strategy. Trading on equity has become a popular method among firms looking to maximize shareholder wealth without diluting their equity.

For a company to grow and become profitable, it needs a lot of capital. Trading on equity is one of the many financial strategies that companies use to gain access to funds. Furthermore, there are two different types of trading on equity that most companies employ – trading on thin equity and trading on thick equity. Wish to know more about this unique financial strategy? Continue reading to find out.

What is Trading on Equity

Also known as financial leverage, trading on equity is a strategy that involves taking on debt to enhance the profits of the company and ultimately the returns to shareholders. 

A company may choose to take on debt through term loans, bonds, debentures or preference share issues. The funds that the company borrows are used to purchase assets that can generate returns or help the company earn more revenue. 

For trading on equity to be successful, the company employing the strategy must generate more revenue than the overall cost of borrowing. 

Let’s take a quick look at a hypothetical example to better understand this unique financial concept.

Assume there’s a company A with a total equity of ₹50 crores. The company decides to borrow funds to the tune of ₹20 crores by issuing debentures. The rate of interest on the debentures is 12% per annum. The company plans to use the borrowed funds (₹20 crores) to purchase a few assets that would help it generate more income, boost profitability and enhance the returns to its shareholders. 

Now, the interest cost on the borrowed funds comes up to about ₹2.40 crores per annum (₹20 crores x 12%). Thanks to the efficient use of the borrowed funds, the company’s revenue has increased by about ₹3 crores per annum. Since the revenue earned by it is more than the cost of the borrowed funds, the company’s trading on equity strategy is successful. 

Now that you’re clear about the meaning of trading on equity, let’s dive into the types of trading on equity.

What are the Different Types of Trading on Equity? 

Trading on equity can be classified into two types – trading on thin equity and trading on thick equity. Here’s a closer look at each of these two types. 

  • Trading on Thin Equity 

If the debt capital of a company is higher than its equity capital, it is said to be trading on thin equity. For instance, if the borrowed funds are ₹50 crores and its equity share capital is ₹45 crores, then the company is said to be trading on thin equity. 

  • Trading on Thick Equity 

On the contrary, if the debt capital of a company is lower than its equity capital, it is said to be trading on thick equity. In the first example, the company’s debt capital was just ₹20 crores, whereas its equity capital was ₹50 crores. This is a classic case of a company trading on thick equity. 

What are the Advantages of Trading on Equity? 

A company that uses the trading on equity strategy gets to enjoy a host of different benefits. Here’s a quick overview of some of the key advantages. 

  • Improved Revenues 

As you’ve already seen, the primary purpose of the trading on equity strategy is to enable companies to generate more revenue. When executed right, a company can significantly enhance the revenues, profits and ultimately the returns to the investors. 

  • Tax Benefits 

Another major advantage of trading on equity is the tax benefit that it offers. The interest cost on borrowed funds is a tax-deductible expense. This effectively means that the company can lower its total taxable income by claiming the interest paid on the borrowed amount as a deduction. This will help lower the amount of taxes that it has to pay to the government. 

  • Prevents Dilution of Ownership 

For companies, there are two types of funding options available – equity financing and debt financing. Equity financing involves the issue of equity shares to the public in exchange for funds. 

Though this method of financing may be more cost-effective than debt, it will dilute the ownership and control of the company since it will lead to more equity shares in circulation. Debt financing, on the other hand, will not cause any such dilution of ownership. The company will get to retain control over its business operations as it is. This is one of the primary reasons why trading on equity is widely preferred. 

What are the Disadvantages of Trading on Equity?

Trading on equity also has a few drawbacks. Let’s take a look at some of the most important disadvantages of this financial strategy. 

  • Increase in Financial Burden

With trading on equity, the company has to regularly service the debt by paying interest to the borrowers. If the borrowed amount is high, the interest payouts alone can increase the company’s financial burden significantly. Furthermore, if there’s any unexpected rise in interest rates, the company may have to pay additional interest on its loans. 

  • Bankruptcy 

If a company is breaking even or under a slight loss, opting for the trading on equity strategy can end up deepening its losses. Sustained periods of losses may even lead the business toward bankruptcy. 

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

Many people often confuse trading on equity with equity trading, but these are two distinct concepts.

Trading on equity refers to the financial strategy where a company uses borrowed funds (debt) to generate higher returns for shareholders. In this context, companies take advantage of their fixed-cost debt securities to enhance earnings on equity. The primary focus is on increasing the profitability for shareholders by amplifying the financial leverage.

On the other hand, equity trading pertains to the buying and selling of shares in the stock market. Investors and traders engage in equity trading to profit from the price movements of stocks. The aim here is to make short-term or long-term gains based on the market conditions and stock performance. Equity trading can be conducted through different strategies, such as day trading, swing trading, or long-term investment.

Thus, while trading on equity is a corporate strategy to enhance returns using leverage, equity trading is a market activity carried out by investors to buy and sell shares for profit.

Trading on equity and equity trading are two distinct concepts in the financial world, often misunderstood due to their similar names.

Trading on equity refers to the use of borrowed funds to increase the potential return on equity. This practice involves taking on debt to acquire more assets, aiming to generate higher profits for shareholders. When a company engages in trading on equity, it leverages its debt to enhance the earnings available to equity shareholders. This can magnify both gains and losses, making it a strategy that carries significant risk but also the potential for substantial rewards.

On the other hand, equity trading involves buying and selling shares of a company on the stock market. Equity traders invest in company stocks, aiming to profit from price fluctuations. Unlike trading on equity, equity trading does not involve borrowing funds. Instead, it focuses on market movements and the strategic buying and selling of stocks to achieve financial gains.  

Conclusion

With this, you must now be well-versed in the meaning of trading on equity. Many Indian companies routinely use this strategy as a means to enhance their revenue and profitability. However, it is a double-edged sword and can also lead to deep losses if the company fails to generate more revenue than the overall cost of borrowing.

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Frequently Asked Questions

How many types of equity trading are there?

Answer Field

There are primarily three types of equity trading:

·       Day trading: Buying and selling stocks within the same trading day.

·       Swing trading: Holding stocks for several days or weeks to capture price fluctuations.

·       Long-term investing: Holding stocks for a prolonged period to benefit from price appreciation and dividends.

What are the two conditions necessary for trading on equity?

Answer Field

The two key conditions for trading on equity to work effectively are:

·       The company must have a stable and sufficient income to meet its debt obligations.

·       The returns on the borrowed funds must exceed the cost of borrowing (interest expenses).

What is the primary benefit of equity trading?

Answer Field

 The main benefit of equity trading is the potential to earn profits through buying and selling shares. Investors can capitalize on market fluctuations, dividends, and long-term capital appreciation, depending on their investment strategy.

What is the meaning of trading on equity?

Answer Field

Trading on equity meaning refers to the use of borrowed funds or debt by a company to increase the potential returns on equity shareholders' investments. By using leverage, companies aim to boost their earnings while maintaining the equity base.

What type of equity trading is best?

Answer Field

The best type of equity trading depends on the investor's risk tolerance, goals, and time horizon. For short-term gains, day trading or swing trading may be suitable. However, for long-term wealth creation, long-term equity investing is often considered a reliable approach.

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