Trading on Equity: What Is It and Why Is It Used?
Large companies might find themselves overburdened with losses which can affect their profitability and reduce investors’ interest. Trading on equity is an important tool used by such companies in the stock markets to manage debt and increase shareholders’ returns. It also plays a pivotal role in improving its brand image.
However, as investors, you should not confuse trading on equity with equity trading or use these terms alternatively.
So what is trading on equity and who does it benefit? Scroll till the end to know all about trading on equity.
What Is Trading on Equity?
Also known as financial leverage, trading on equity is a process where a company issues certain types of debt using instruments such as convertible notes, debentures, and long-term loans. Then, the company uses this debt to invest in assets that generate returns larger than the interest on the debt.
In case, a company bags more ROI than the cost of debt, it means higher returns for equity shareholders. However, if they fail, equity shareholders may have to bear losses. Many companies use financial leverage to protect their equity capital and improve their Earnings Per Share (EPS). This tool is recommended in situations where the rate of returns from investments is higher than expenses on interest payment.
What Are the Objectives of Trading on Equity?
Companies opt for trading on equity to fulfil these objectives.
- They aim to increase earnings for equity investors by opting for debt. This attracts new investors which increases capital flow in the company over the long term.
- It allows them to have stronger control over their company’s ownership.
- By offering more returns and holding investors for longer periods, companies improve their brand image.
What Are the Types of Trading on Equity?
There are two main types of trading on equity strategies based on the debt and equity funding structure of a company:
- Trading on Thin Equity
Very often, a company’s equity capital is significantly lower than its debt capital. In such cases, a company is referred to as trading on thin equity. For example, if Company X’s debt capital is ₹400 crore and equity capital is ₹100 crore, it is trading on thin equity. However, NBFCs (Non Banking Financial Companies) are mandatorily required to maintain a CAR of 15%, so efficiently they can go to debt of ~6% of the equity base.
- Trading on Thick Equity
When a company’s equity capital is substantially higher than its debt capital, it is said to be trading on thick equity. For instance, a company’s equity capital is ₹300 Crores and its debt is ₹50 Crores. Here, this company is trading on thick equity.
What Are the Benefits of Trading on Equity?
The benefits of trading on equity for the company are as follows:
- Tax Benefits
Interest expenses on funds borrowed by a company are tax-deductible. As a result, the firm will have to pay comparatively lower taxes. While dividends and distributions paid to shareholders are after-tax distributions.
- Enhances Earning
By trading on equity, a company can generate a higher Return On Equity (ROE). In such instances, the company’s shareholders get better returns.
- Improves Company Goodwill
With trading on equity, firms can provide higher ROI to their equity shareholders. This plays a vital role in improving company goodwill in the eyes of investors.
What Are the Disadvantages of Trading on Equity?
Here are a few disadvantages that companies are likely to face while trading on equity:
- Subject to Risk and Uncertainty
Trading on equity comes with the risk that the company may face major loss, if it can not generate higher returns than the cost of borrowing. Therefore, you can say, trading on equity is suitable for firms that have a high-risk appetite to overcome such losses.
- Sudden Increase in Interest expenses
If a company opts for a higher amount of debt, then there will be a huge increase in the company’s debt payment obligations. In the scenario of rising interest rates, it might have to borrow at substantially higher rates which can result in huge losses, if desired returns are not generated from deployed funds. Therefore, along with chances of high ROI, there is also a probability of losses with trading on equity.
Trading on equity is a strategy that companies use to expand their business and reward their shareholders. With this strategy, firms can generate more ROI along with attracting more investors for a longer tenure. It is also important to note that trading on equity may benefit company shareholders, but it can also result in huge losses as well, if leverage is not managed properly.
Frequently Asked Questions
Who can apply to trade on equity strategy?
The strategy of trading on equity fits well for companies with higher risk appetite. Companies that are confident to earn a substantial amount on borrowed funds can opt for this tool.
Why do companies opt for trading on equity?
Companies tend to go for trading on equity tools to offer equity shareholders higher returns on their investments.
How can you measure the effects of trading on equity?
You can analyse the effects of trading on equity on a company’s finances by two important metrics. These include the ROE and the degree of financial leverage.