One of the many financial strategies that corporates use to secure funding is ‘trading on equity’ also called financial leverage. Although the name says trading on equity, it is not the same as equity trading. In fact, it does not involve equity, instead, it involves debt capital in the form of debentures, bonds, preference shares, etc. secured by the company to fund the day-to-day business operations.
As a trader, it is crucial for you to understand what is trading on equity to better assess the financial position and future growth prospects of a company. So, let us explain more about it.
What is Trading on Equity?
Trading on equity is a strategy where a company procures new debt instruments in the form of debentures, bonds, preference shares, or loans to acquire new assets or invest in a new avenue with the aim of generating returns. The intention of the company is to earn a return greater than the interest cost of the debt thus generating returns for its shareholders.
If the company generates a profit through this financing technique, earning greater returns on investment for its shareholders, the strategy carried out by the company can be called fruitful. However, if the strategy results in lower earnings compared to interest expense, decreasing shareholders’ income, that shows that the strategy was unsuccessful.
Instead of acquiring more equity capital, many corporates resort to trading on equity with an eye towards improving their earnings per share.
Let us simplify the concept of trading on equity with the help of an example.
Example of Trading on Equity
Let us say, Max Limited has a current capital structure of Rs. 6 lakh as equity capital (Rs. 10 per share). They plan for an expansion for which they are looking out for financing options to secure further Rs. 4 lakh. Their options are as follows:
- Option 1 – Issue ordinary shares worth Rs. 4 lakh
- Option 2 – Issue ordinary shares worth Rs. 2 lakh and procure Rs. 2 lakh by way of debt at 5%
- Option 3 – procure Rs. 4 lakh by way of debt at 6%
- Option 4 – Issue common stocks worth Rs. 2 lakh and issue 5% preference shares worth Rs. 2 lakh
Max Limited expects an EBIT of Rs. 240000.
Trading on equity Formula
Rate of Return for Shareholders = (Profit – Debt * Cost of Debt) / Equity.
|Particulars||Option 1||Option 2||Option 3||Option 4|
|Earnings Before Interest and Tax (Rs.)||240000||240000||240000||240000|
|Less: Interest (Rs.)||–||10000||24000||–|
|Earnings Before Tax (Rs.)||240000||230000||216000||240000|
|Less: Taxes @50% (Rs.)||120000||115000||108000||120000|
|Earnings After Taxes (Rs.)||120000||115000||108000||120000|
|Less: Dividend to preference shareholders (Rs.)||–||–||–||10000|
|Earnings available to shareholders (Rs.)||120000||115000||108000||110000|
|Number of shareholders||100000||80000||60000||80000|
|Earnings Per Share (Rs.)||1.2||1.43||1.8||1.37|
The above example highlights that Max Limited can increase the earnings of shareholders by choosing option 3 which is a pure debt approach.
Types of Trading on Equity
Based on the size of debt funding relative to available equity, it is classified into two types:
- Trading on Thin Equity – Where the equity capital of a company is less than its debt capital.
- Trading on Thick Equity – Where the equity capital of a company is more than its debt capital.
Advantages of Trading on Equity
- Enhanced Earnings
It allows the company to enhance its earnings by investing in new avenues and assets which can further generate more returns.
- Tax Benefit
The interest expense on borrowed funds is tax deductible this means the company has to pay lower tax thus resulting in a lower cost of borrowing.
In simple words, we can say that trading on equity is a strategy for companies to procure more funds to purchase new assets, and uses these new assets to pay for their debt.
After reading this article we hope that you are in a better position to evaluate companies that utilize this strategy before investing your hard-earned money.