Trading on equity is financing the purchase of assets by a company with debt or borrowed money. Using borrowed funds to invest in assets or projects that yield returns greater than the cost of borrowing is a financial strategy businesses use to increase returns to shareholders. Businesses looking to maximize shareholder value and optimize their capital structure have been using this financial strategy for decades.
What is Trading on Equity?
As previously stated, companies use equity trading to increase revenue through acquiring new assets and the subsequent generation of returns greater than the debt they take on. Consequently, the surplus income raises the earnings per share (EPS) for shareholders. It is evidence that a corporation’s strategy was successful.
If, on the other hand, the plan does not work out as planned, earnings will be less than interest expense. As a result, the income of the shareholder decreases. That is a sign that the strategy was not successfully implemented.
What Are the Objectives of Trading on Equity?
- It gives them more authority over the ownership of their business.
- By using debt, they hope to boost returns for stockholders. Long-term capital flow into the business is increased as a result of attracting new investors.
- Companies enhance their reputation by providing greater returns and keeping investors for extended periods.
What Are the Types of Trading on Equity?
- Trading on Thin Equity: A company’s equity capital is frequently much less than its debt capital. A company is said to be trading on thin equity in such circumstances. For instance, Company X is trading on thin equity if its debt capital is ₹400 crore and its equity capital is ₹100 crore. NBFCs, or non-banking financial companies, must, nevertheless, consistently maintain a CAR of 15%, which allows them to effectively incur debt equivalent to less than 6% of their equity base.
- Trading on Thick Equity: A company is considered to be trading on thick equity if its equity capital is significantly greater than its debt capital. For example, a company has ₹50 crores in debt and ₹300 crores in equity capital. This business is trading with substantial equity.
What Are the Benefits of Trading on Equity?
- Tax Benefits: Interest paid by a business on borrowed funds is tax deductible. Consequently, the company will incur relatively lower tax obligations. Dividends and other payments made to shareholders are made after taxes.
- Enhances Earning: A business can increase its Return On Equity (ROE) by trading on equity. The company’s shareholders benefit from higher returns in these situations.
- Improves Company Goodwill: Companies can give their equity shareholders a better return on investment through equity trading. This is essential to enhancing the company’s reputation among investors.
Difference Between Trading on Equity and Equity Trading
People frequently mix up the terms equity trading and trading on equity. However, there are significant conceptual differences between these two terms. Equity trading involves buying and selling stocks, even though it’s a financial strategy meant to increase shareholder earnings.
Company managers engage in and carry out equity trading, although equity trading can be carried out by any person or organization. Managers try to profit from the discrepancy between interest on debt and return on investments through equity trading. Conversely, through equity trading, whether done offline or online, investors aim to profit from fluctuations in share prices by purchasing stocks at a lower price and selling them at a higher price.
Therefore, to eliminate any confusion that may be present, it is essential to understand the distinctions between and the meanings of each of these concepts.
FAQ for Trading on Equity
Q1. To trade using an equity strategy, who can apply?
Ans. Trading on equity is a suitable strategy for companies that have a greater tolerance for risk. Businesses that have faith in their ability to make a sizable profit on loans may choose to use this tool.
Q2. Why do businesses choose to trade stocks?
Ans. Businesses typically use equity tool trading to give equity shareholders greater returns on their investments.
Q3. How can the impact of trading on equity be quantified?
Ans. Two key metrics can be used to analyze how trading on equity affects a company’s financial position. These consist of the level of financial leverage and the ROE.