Trading on Equity Meaning—Trading on equity means using the borrowed capital to generate revenue that boosts the profits of equity shareholders, i.e., to make the profits by investing in the debt higher than the loan’s interest costs.
Financial leverage also refers to trading on equity.
Trading on equity in financial management involves a strategy where a company takes debt as bonds, debentures, loans, or preferred stocks. A company applies this strategy to increase the equity shareholder’s return on investment.
The borrowed funds such as bonds, debentures, loans, or preferred stocks are used to buy assets for the company that can help them earn more revenue than the cost of the borrowed funds.
Companies use this method of financing when they believe the assets will generate more profits than the borrowed principal and interest amount paid on the debt. This financial process increases equity shareholders’ wealth. As a result, the value of the shares rises.
Trading on Equity Example:
Company Y has borrowed Rs.100 crores as debt funds at a 10% interest rate. Later, the company used the debt to buy an asset (factory) to generate more income.
Here, company Y pays interest amounts of around Rs.10 crores while the income generated from the asset amounts to Rs.20 crores.
We can say that the company was successful in using the trading on equity strategy by enhancing its revenue-generating capacity.
What is The Purpose of Trading on Equity?
In the capital structure, a company may fund itself with debt or equity. If the company uses more debt to finance initiatives, it will have to pay fixed interest, which is less expensive than the cost of equity capital.
After paying the fixed interest on the debts, there will be profit left over for the current shareholders.
If additional shares are issued, more equity shareholders will benefit from the gain. As a result, when profits are substantial, companies use low-cost debt rather than increasing the number of shareholders to divide the earnings or raise money for a project.
- The primary purpose is to increase the wealth of the shareholders.
- Trading on equity is employed when the company wants more finance from debt sources rather than equity.
- The company uses this strategy to ensure that control over the company remains the same.
- A company might also use the trading on equity strategy to increase the company’s market share price.
Advantages And Disadvantages of Trading on Equity
Trading on equity advantages and disadvantages are as follows:
Advantages of Trading on Equity Include:
- It gives the company access to extra capital, which makes it possible to invest in assets that will generate a profit.
- As the interest on a loan is tax deductible, the company pays less amount in taxes overall.
Disadvantages of Trading on Equity Include:
- Trading on equity involves disadvantages as well. The inability of the company to pay back the interest for any reason is one of the primary disadvantages it faces.
- Similarly, the company’s liabilities may grow if interest rates rise.
- The borrowed debt funds may not fulfill the purpose for which it is borrowed.
- In the worst scenario, the company can also become bankrupt.
Types of Trading on Equity
Below are the two types of trading on equity:
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Trading on thin equity
In trading on thin equity, the borrowed amount is significantly close to the company’s equity because the company’s capital is lower than the debt capital.
For example, if company X’s equity capital amounts to Rs.100 crores whereas the debt capital amounts to Rs.300 crores, company X is said to be trading on thin equity.
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Trading on thick equity
In trading on thick equity, a company borrows a small amount close to its equity because the company’s equity capital is higher than the debt capital.
For example, if company X’s equity capital amounts to Rs.300 crores whereas the debt capital amounts to Rs.50 crores, company X is said to be trading on thick equity.
What is The Difference Between Trading on Equity And Equity Trading?
There is a big difference between trading on equity and equity trading. Trading on equity is about using debt in the capital structure, also known as financial leverage, to raise earnings per share (EPS).
Whereas equity trading involves selling and purchasing shares for more profit. Companies use equity trading as a strategy to create value for their shareholders by using their stock as security for loans.
Since equity is so dependable, a company that already has equity and needs additional funds might borrow money on favorable terms. With the help of these funds, the company can purchase assets that generate returns higher than the debt's interest rate.
Many companies prefer to use this strategy over the trading on equity method to raise the Earnings Per Share (EPS) of their shares.
Takeaway
Equity trading involves borrowing funds but does not involve raising more money from existing shareholders. Using this strategy, a company can boost share value and generate returns higher than the interest cost on debt-financed investments.
FAQs
What is the primary benefit of equity trading?
Equity trading allows organizations to earn appropriate assets by employing debt financing. The income earned using assets can help pay off the interest amount on borrowed funds. Also, the interest expense is tax-deductible.
Is the strategy of trading on equity safe to employ by a company?
A company is safe to employ the trading on equity strategy as long as the company is confident of earning excess income over borrowed funds and does not go bankrupt in the long run.
There is a real risk if the company goes bankrupt or does not generate maximum returns.
How many types of trading on equity are there?
Trading on thin equity and trading on thick equity are two different types. In trading on thin equity, the borrowed amount is close to the company’s equity because the company’s capital is lower than the debt capital.
In contrast, a company that trades on thick equity borrows a little sum that is near its equity because its equity capital is bigger than its debt capital.
What are the risks associated with equity trading?
When an organization encounters uneven earnings or earnings that are lower than expected, a major risk comes with trading on equity or risk that it could bring to an organization. The interest paid on borrowed money is an unavoidable expense for the organization.
The cost burden grows when assets purchased with borrowed money are not expected to generate the expected income. Another risk is that the business won’t be able to cover its cost of capital in the long run.
How is the company’s income statement affected when interest rates rise before the end of the repayment period?
The company has to bear extra interest rate payments, which can affect its overall income statement.