Trading on Equity: Everything You Need to Know

How to borrowing by trading on equity?

If you have heard the term trading on equity, remember it is not about stock market trading. Here, trading on equity means using equity as leverage to raise debt. Normally, if you have your own funds, it is easy to get loan from a bank. That is what is trading on equity. It is about using your equity base to raise debt to reduce cost of capital. Now what is equity trading and how it is different from trading on equity is what we will see here.

When you have a strong equity base and a low debt equity ratio, it allows you to raise more of debt capital. Now debt has lower cost of funds compared to equity so it is more value accretive to shareholders. What is meant by trading on equity is that you use your strong equity base to enhance your debt in a measured manner. This is not so much about how to trade in equity market but how to trade on equity as a funding source.

In this segment we will define trading on equity as a concept and also look at the pros and cons of trading on equity. We shall also look at trading on thin equity and compare it with trading on thick equity.

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Understanding the concept of trading on equity

Trading on equity is normally considered to be an important corporate finance  strategy. In corporate finance, the CFO and the board have to decide the capital structure of the company. Now, this capital structure has to be optimal. Too much debt can be a solvency risk as the company may or may not be able to afford regular interest pay outs and debt servicing. On the other hand, too much equity can also be counterproductive since it will dilute the equity beyond a point and make the earnings per share much lesser and thus depress the value of the stock. That is where trading on equity comes in handy where you decide on how to leverage your equity base to selectively add debt to your capital.

Typically, any listed or unlisted company with a viable business model and steady cash flows can manage to procure debts in the form of loans, bonds, debentures, and more. Companies are constantly trying to work on two things. Firstly, how to growth the business by raising and allocating capital either via debt or via equity. Secondly, challenge is to service the capital. Both equity and debt have to be serviced. In the case of debt, servicing is a lot simpler as it involves payment of interest and principal on time. However, equity also has a cost in that if the equity shareholders are not happy and if they are earning less than the expected rate of return, the price will fall and reduce the value of the company overall.

Trading on equity is a very smart and delicate trade off, almost like walking on thin ice. If you rely only on equity, you are losing out an opportunity to add value to shareholders by relying on lower cost debt. However, if you rely too much on debt, then there are consequences for the solvency of the company, and also its valuations. Either ways, a wrong decision on the quantum of debt can be an important deciding factor for the valuation of the company as measured by the market capitalization of the company. That is there trading on equity gives clues about the proportion of debt to back the equity.

Trading on thin equity and trading on thick equity

We have already seen the concept of trading on equity in fairly elaborate detail. To just summarize our concept, trading on equity is also known in stock market parlance as financial leverage. This is nothing but using the equity strength of the company to get debt from their creditors and tweak the capital structure of the company towards a lower cost structure. Here we look at 2 principal types of trading on equity i.e. trading on thin equity and trading on thick equity.

1. Let us first and foremost look at Trading On Thin Equity. This is a rather common scenario in corporate finance. Trading on thin equity occurs when the equity capital present for a company is quite lower compared to its debt capital. For instance, a debt equity ratio of 3:1 or 4:1 is already quite high. Here the scope for adding debt by trading on equity is quite thin and this is called trading on thin equity. For such companies, too much of debt addition is neither possible nor advisable as it would substantially add to their solvency risk.
2. Let us not turn and look at Trading On Thick Equity. This is in exact contrast to trading on thin equity. Trading on thick equity is not a very common scenario in corporate finance since not many companies are really strongly equipped in terms of their leverage ratios. Trading on thick equity occurs when the equity capital present for a company is quite high compared to its debt capital. For instance, a debt equity ratio of 0.25:1 or 0.35:1 is already quite low on debt and can give a lot of leeway to the company to trade on equity to reduce cost of capital and to enhance market valuations. Here the scope for adding debt by trading on equity is quite high and thick and this is called trading on thick equity. For such companies, relatively higher debt addition is possible and also advisable as it would substantially lower their weighted average cost of capital and also enhance the market valuations.

How trading on equity adds value to a company?

Here is how trading on equity adds value to a company and enhances its valuations.

• The first is the tax factor and how debt reduces its tax outgo. For instance, when a company trades on equity and borrows funds, they have to pay interest on the debt take. The good news is that the interest on debt is a deductible expense on the P&L account and to that extent it reduces the tax burden of the company. On the other hand, for the company, the dividend paid on equity is a post-tax appropriation and hence there is no tax deduction on that.
• Debt reduces the cost of capital as debt has a lower cost of capital compared to equity. In the case of equity, the expected rate of return is much higher. This reduces the weighted average cost of capital and enhances valuations since future cash flows are now being discounted at a lower hurdle rate.

 Points to remember when you trade on equity

Let us sum up the discussion on trading on equity with some key takeaways or points to remember here.

• Changing the capital structure and adding the equity does not change the normal risk of the business. It only tweaks the risk of capital mix.
• Trading on equity only considers the obvious debt on the balance sheet. However, for a clearer picture, you must also consider the off balance sheet items.
• Trading on equity always has a cost in terms of solvency risk. Hence interest coverage ratios and debt service coverage ratios must be properly evaluated.
• The cash flows matter since debt is serviced out of cash flows. Even if profits are good and cash flows are weak, it can hamper debt servicing. This must be kept in mind.
• Debt is always vulnerable to a spike in interest rates as we are seeing now in the Indian markets. When interest rates rise, fresh borrowings or renewal of old debt has to be done at a higher market driven rate. This brings in the risk of bankruptcy and cash flows pressure for the company. Sensitivity tests and stress tests are essential beforehand.

Key takeways from the trading on equity idea?

Let us address the primary question, should a company indulge in trading on equity or not. Here are some ground rules. If the company is a recent company or if it has cyclical cash flows, then it is better not to trade on equity. That is a strategy suited more to companies with stable cash flows. However, for established companies with low debt equity ratios, trading on equity can be a veritable method of reducing the cost of capital and enhancing the valuation of the company in the market. One condition is that the company must set milestones for reduction of debt, so that solvency does not become an issue in future.