BAJAJ BROKING
August 01, 2023
7 mins read
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.
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.
Trading on equity, also known as financial leverage, refers to a company's strategy of using borrowed funds to boost shareholder returns. By leveraging its equity strength, a company raises debt from creditors, aiming to enhance earnings and maximise profitability. This approach allows businesses to expand operations, invest in growth, and improve overall financial performance without diluting ownership. However, while trading on equity can amplify gains, it also increases financial risk, making it crucial for companies to manage debt efficiently.
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.
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.
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.
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.
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.
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.
Trading on equity also has a few drawbacks. Let’s take a look at some of the most important disadvantages of this financial strategy.
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.
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.
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 fixed-cost financial instruments like debt and preference shares to increase the return on equity. It involves leveraging borrowed funds to generate higher returns for equity shareholders. When earnings exceed the cost of debt, the additional profits amplify returns for shareholders. However, if earnings fall, fixed costs can magnify losses.
The effect of trading on equity can be both beneficial and risky. A company with stable income can use debt to boost earnings per share (EPS). But excessive use of debt increases financial risk, especially in volatile markets. The key lies in optimising the capital structure to balance returns and risk efficiently.
Measuring the Effects of Trading on Equity
Since trading on equity can be a complex concept, it is easier to understand with a simple example. Let’s assume that Aster Limited plans to raise ₹4 lakh to finance its expansion project. The company currently has ₹4 lakh in equity capital, with shares valued at ₹10 each. To arrange the required funds, the management is considering four financing strategies:
The company projects an Earnings Before Interest and Tax (EBIT) of ₹2,40,000 from the proposed expansion. The table below presents how each funding option affects the Earnings Per Share (EPS):
Particulars | Option 1 | Option 2 | Option 3 | Option 4 |
EBIT | ₹2,40,000 | ₹2,40,000 | ₹2,40,000 | ₹2,40,000 |
Less: Interest | Nil | ₹10,000 | ₹24,000 | Nil |
EBT | ₹2,40,000 | ₹2,30,000 | ₹2,16,000 | ₹2,40,000 |
Less: Taxes @ 50% | ₹1,20,000 | ₹1,15,000 | ₹1,08,000 | ₹1,20,000 |
Earnings After Taxes (EAT) | ₹1,20,000 | ₹1,15,000 | ₹1,08,000 | ₹1,20,000 |
Less: Dividend to preference shareholders | Nil | Nil | Nil | ₹10,000 |
Earnings available to shareholders | ₹1,20,000 | ₹1,15,000 | ₹1,08,000 | ₹1,10,000 |
Number of shares (₹10 each) | 80,000 | 60,000 | 40,000 | 60,000 |
EPS | ₹1.50 | ₹1.92 | ₹2.70 | ₹1.83 |
This example highlights how the use of fixed-cost capital, like debt and preference shares, can increase EPS. However, it also raises financial obligations. Therefore, selecting the right capital structure is crucial to ensure a healthy balance between returns and financial risk.
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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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.
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).
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.
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.
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.
The objective of trading on equity is to increase the return on equity shareholders’ funds by using fixed-cost capital like debt or preference shares. When earnings exceed the cost of such capital, it enhances earnings per share (EPS), thereby improving shareholder returns.
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