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 this strategy is leverage in finance. Companies anticipate that by trading on equity, 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 (earnings 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. Let’s understand trading on equity meaning in this blog using some examples along with their advantages and drawbacks.

Example of Trading on Equity 

Now that you know what is meant by trading on equity, let’s look at the trading on equity example to better understand this strategy. At a 10% interest rate, Company ABC has taken out a debt loan for ₹10 crores. Later, the business bought a factory with debt to increase revenue. Company ABC currently pays interest payments of about ₹1 crore, whereas the asset's income is worth ₹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 funds by selling bonds, debentures, or similar interest-bearing securities and then invests the funds in successful ventures or assets. On borrowed sum, 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 funds, which it then invests in successful endeavors or property. A tax-deductible set dividend that the corporation must pay on its preferred shares.

Advantages of Trading On Equity

Trading on equity allows companies to increase their return on equity by using borrowed funds to finance growth. Here are the key benefits offered by this strategy.

• Increased profits: By taking out the required loans, the business opens up new revenue streams for itself by acquiring new assets.
• Favourable tax treatment: Interest paid on the borrowed funds is tax deductible. Thus, the tax burden on the borrowing firm is reduced. Thus, in essence, the borrower's overall expenses are decreased as a result of the additional debt.
• Increased returns: Creating larger returns for shareholders is the main benefit of trading equities. The company's shareholders win from higher earnings if its investments generate returns higher than the interest costs on the loan.
• Leverage: By trading equity, a business can acquire more capital by making use of its current equity basis. For businesses that are focused on growth but may not have enough internal resources for expansion, this can be especially helpful.

Disadvantages of Trading on Equity

Now that you know what you mean by trading on equity and its advantages, it is essential to understand its drawbacks too. 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.
• 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 capital 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 funds may be used.

What Distinguishes Equity Trading from Trading on Equity?

Equity trading involves buying and selling shares of companies. However, trading on equity refers to using borrowed funds to increase potential returns on investment. The following table distinguishes equity trading from trading on equity.

Conclusion 
An investment approach called trading on equity can give businesses a chance to raise additional capital. Debt and equity trading on equity are the two prominent types used by many companies. However, before introducing trading on equity, companies on the Indian stock market need to carefully evaluate the benefits and drawbacks. Hence, investors should know what is trading on equity in financial management to understand how the companies operate. Trading on equity can, in general, be a useful tool for financing and achieving growth, but it should be used with prudence and good management of risks. You can use a good stock market app to find such financial information about different companies and analyze it before investing.