What is trading on equity?

What is trading on equity?

Trading on equity refers to using fixed-cost financing instruments, such as preference shares, debentures, and long-term loans, in the capital structure, to boost the return on equity shares. Another name for trading on equity is leverage in finance.

Companies anticipate that by trading on equity, as was previously indicated, they will enhance their revenue by purchasing new assets and subsequently provide returns that are greater than the debt they acquire. As a result, the surplus income raises EPS (profits per share). It serves as proof that a company's plan was successful.

If the plan does not work out, it nevertheless yields lower profits than the cost of interest. As a result, the income of the shareholder declines. That is a sign that the strategy wasn't successfully put into action.

Example of Trading on Equity

At a 10% interest rate, Company ABC has taken out a debt loan for Rs. 10 crores. Later, the business bought a factory with debt to increase revenue. Company ABC currently pays interest payments of about Rs. 1 crore, whereas the asset's income is worth Rs. 2 crore.

Types of Equity Trading

Different types of trading on equity are mentioned below.

1. Debt Trading on Equity

In this kind of trading on equity, a business borrows money by selling bonds, debentures, or similar interest-bearing securities and then invests the money in successful ventures or assets. On borrowed money, the business must reimburse a fixed interest rate that may be deducted from taxes.

2. Equity Trading on Equity

In this form of equity trading, a business issues preference shares to collect money, which it then invests in successful endeavours or property. A tax-deductible set dividend that the corporation must pay on its preferred shares.

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Table of Content

  1. Types of Equity Trading
  2. What distinguishes equity trading from trading on equity?
  3. Benefits of Trading on Equity
  4. Negative aspects of trading on equity
  5. The Goal of Trading on Equity
  6. Conclusion

What distinguishes equity trading from trading on equity?

Trading in equity and equity trading are vastly different from one another. Trading on equity involves increasing earnings per share (EPS) by credit in the financing structure, sometimes referred to as financial leverage. 

In contrast, stock trading involves buying and selling shares to increase profits. By leveraging their stock as collateral for loans, businesses employ equity trading as a technique to increase value for their shareholders.

Due to the dependability of equity, a business that currently has equity but requires more funding may be able to borrow money at advantageous terms. With the aid of these funds, the corporation can buy assets that produce returns greater than the interest rate on the debt. To increase the earnings per share (EPS) of their shares, many businesses prefer to employ this approach over the trading on equity option.

Benefits of Trading on Equity

The major advantages of trading on equity are mentioned below.

  • Higher Returns

Trading on equity can result in higher returns because borrowed money can be used to invest in high-yield assets or ventures.

  • Tax Benefits

Because interest on borrowed money is tax deductible, the amount of taxes owed by the corporation may be reduced.

  • Better shareholder value

Trading on equity can boost shareholder value and maximise return on equity capital, which may result in increased stock prices.

  • Simpler access to capital

Equity trading can assist businesses in raising money for development and expansion goals that may not be feasible through financing with equity alone.

Negative aspects of trading on equity

There are some disadvantages to trading on equity, the major negative aspects are mentioned below.

  • High Risk

Trading on equity is a heavy-risk approach since it places a lot of reliance on the notion that the investment's return will exceed the cost of borrowing money.

  • Greater Debt Levels

Trading on equity can raise a firm's debt levels, which could result in greater interest payments and financial difficulties if the company is unable to earn sufficient returns on the invested capital.

  • Higher interest rates

Borrowed money may incur interest charges that are higher than the projected return on investment. The outcome of this leads to negative cash flow.
 

  • Lack of control

Trading on equity may result in the company losing control since the lenders may place limitations on how the borrowed money may be used.

The Goal of Trading on Equity

Trading on equity is done to increase returns on investment by using borrowed money to buy profitable assets or initiatives. By doing so, businesses can increase shareholder value and fund their objectives for growth and expansion. Companies frequently employ trading on equity to lower their overall expenditure of capital or when they are unable to raise enough money through financing with equity.

Conclusion

An investment approach called trading on equity can give businesses a chance to raise additional capital. Before introducing trading on equity, companies on the Indian stock market need to carefully evaluate the benefits and drawbacks. Trading on equity can, in general, be a useful tool for financing advancement and growth goals, but it should be used with prudence and good management of risks.

Disclaimer

*Terms & conditions apply. This is an informational message from blinkX and it is not intended to be an investment recommendation. Securities market investors are exposed to market risk; before investing, thoroughly read all pertinent documentation.


 

What is trading on equity FAQs?

Trading on equity is primarily used to increase returns from investments by using borrowed money to invest in lucrative properties or initiatives. By doing so, businesses can increase shareholder value and finance their objectives for growth and expansion.

Debt trading and equity trading are the two primary forms of trading on equity. By issuing interest-bearing instruments like bonds or debentures, debt trading on equity includes borrowing money, while equity trading on equity includes raising money by issuing preference shares.

While equity trading involves buying and selling shares for a profit, trading on equity requires utilising debt in the financing system to increase earnings per share (EPS). By leveraging their stock as collateral for loans, businesses employ equity trading as a technique to increase value for their shareholders.

When they can't raise enough money via equity financing or because they wish to lower their cost of capital, businesses frequently turn to trade on equity. Companies can increase shareholder value and finance development and expansion by trading on equity. However, before putting this strategy into practice, it's crucial to carefully weigh the risks and advantages.