What is Trading on Equity?
Trading on equity, also called financial leverage, is a process through which a company incurs new debt in bonds, loans, preferred shares, or debentures to acquire additional income. On this, it can earn greater returns than the interest created by the debt.
The method exists primarily to help companies gain the capital to expand and generate profit without immediate cash outlays for interest. It also results in higher returns for the shareholders on their investment.
Example of Trading on Equity
Let's understand this concept better through an example:
Company ABC uses ₹10,00,000 of its own money to buy a factory, which generates ₹2,50,000 of annual profits. There is no financial leverage involved here since the company incurred no debt to buy the factory.
Company XYZ, however, uses ₹1,00,000 of its own cash in addition to a loan of ₹9,00,000 to buy a similar factory. In this case, Company XYZ is using financial leverage to generate extra revenue of ₹2,50,000 on a cash investment of ₹1,00,000. The profit will then be calculated by deducting the loan interest amount from the revenue.
Trading on Thin Equity vs Trading on Thick Equity
company usually gets its loan amount sanctioned with favourable terms from creditors based on the strength of its equity. If the equity capital of a company is lower than the debt capital, it is known to be trading on thin equity. Conversely, trading on thick equity entails having a higher equity capital than debt in the overall structure.
Metrics to Measure Effects of Trading on Equity
As the manager of a company, it's your job to make prudent decisions regarding financing options. Instead of using this method as a fallback, it would be wise to remember that raking up debt isn't the only way to expand a company's income and produce more value for your shareholders. Your organization can accomplish the same result by issuing ordinary shares or striking a balance between the two methods — taking on some debt and issuing shares.
To measure the impact of trading on equity, these are the two most commonly used parameters:
Capital Gearing Ratio: This defines the degree to which a company's capitalization depends on its equity. The formula is as follows:
Capital Gearing Ratio = (Debentures + Preference Capital) / Shareholder’s Equity
Degree of Financial Leverage: This provides information about how your earnings per share (EPS) will fluctuate with respect to change in earnings before interest and taxes (EBIT). The formula for this one is:
Degree of Financial Leverage = Percentage Change in EPS / Percentage Change in EBIT
Benefits of Trading on EquityApart from enhanced earnings for the company and its shareholders, there are two main advantages of trading in India on equity.
- Favourable Tax Treatment
The interest expense on borrowed funds is tax-deductible. Interest on debt is an expenditure that is accounted for before the deduction of tax, thereby reducing the company's overall tax liability. Essentially, the new debt results in a reduction of the total costs for the borrower.
- Lower Debt-Servicing Costs
Another advantage of trading on equity is the lower debt-servicing cost. For instance, a company procuring 10% debentures and 10% preference shares can earn a higher pre-tax income to service the preference shares compared to the pre-tax income required to service the debt.
Disadvantages of Trading on Equity
Trading on equity comes with its own set of risk factors, particularly when the borrowed amount and overall capital cost are not down to the level of reasonable risk the company can digest.
- Presents the Possibility of Extreme Losses
The interest expense holds the potential to overwhelm the borrower if they are unable to earn sufficient returns to offset it. This can lead to further losses in the business or even bankruptcy. The possibility gets more dangerous in situations where a company relies upon short-term borrowings to fund its operations.
However, this risk can be mitigated through interest rate swaps, wherein a company swaps its variable interest payments for the fixed interest payments of another entity.
Trading on equity is a trade-off by definition. A company uses its equity to get new funds to purchase new assets, which in turn are used to serve its debt or dividend obligations. The greater the debt share in a company's capital structure, the more significant the EPS variation with respect to the fluctuation in EBIT. Trading on equity may result in unstable earnings, thereby impacting stock options by increasing their recognized cost. The company must be as well-read as possible about each of these concepts so that there's no confusion and unnecessary losses.
- Adverse Impact on Shareholders
Volatile income and profits can impact the shareholders' return unfavourably. At times, it can also result in the overcapitalization of the borrowing entity.
Also Read: Equity vs Commodity Trading
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Frequently Asked Questions
Return on equity is the measure of a company's profitability in relation to shareholders' equity. The formula by which it's calculated is as follows:
Return on Equity = Net Income / Shareholders’ Equity
Trading in India on equity is likely to be lucrative for a company if it is well-established and has regular, stable revenue and profits along with ample liquidity to allow for large-scale borrowing. The nature of the company's business should not be speculative.
People often get these two processes mixed up. In simple words, trading on equity is a financial strategy executed by company managers to seek profits from the difference between returns on investments and interest on debts, which enhances shareholder's earnings.
Equity trading online is a practice that any individual or entity can undertake with a trading account. Equity trading in India is all about trading online and capitalizing on changes in share price by buying stocks at a discount and selling them at a premium.