What is trading on Equity? Explained Simply

Picture a company that wants to grow but doesn’t want to issue new shares. What can it do? It can borrow money with the aim of earning more from the investment towards growth than the interest it pays. When done right, it generates profits for the existing shareholders.

This strategy of using debt to drive higher returns is known as trading on equity. Here, trading doesn’t literally mean trading, but leveraging the strength of equity to raise debt and earn higher returns on that.

Read this blog to dive deeper into understanding ‘what is trading on equity?’, how it works, types, and the benefits to the company and shareholders.

What is trading on Equity?

Trading on equity is a financial strategy in which a company uses debt, such as bonds, loans, or preference shares, to invest in assets, while aiming to earn returns higher than the interest on debt. This process increases profits and drives earnings for the shareholders.

The word ‘trading’ here refers to leveraging or making use of the equity base, not literally trading it. This is called trading on equity because a company uses its equity as a bait to raise debt. But how? A company’s equity base, that is, its existing shareholder capital and retained earnings, acts as a measure of financial strength. 

When a company already has a solid equity base, banks and investors are more willing to lend, because it lowers their risk. So, trading on equity is about using the strength or authenticity of the existing equity to raise debt and then earn higher returns on that borrowed money.

Let’s take an example, imagine Tata Motors plans to expand its electric vehicle division. The company already has ₹20,000 Cr of equity funds, including shareholder funds and retained earnings. For this, Tata Motors borrows ₹10,000 Cr through bonds at an annual interest rate of 8%, rather than issuing new shares.

Now, if the EV project generates a 15% return, the company earns more than it pays in interest. That extra 7% goes to the shareholders as profits without any dilution.

However, if returns are low or below the cost of debt, leverage works in reverse and reduces the shareholders’ value. So in our example,  if the market slows and returns drop to 6%, the cost of borrowing overtakes the gains, cutting the profits, reducing shareholder value.

How Does Trading on Equity Work?

• Leveraging on equity: In trading on equity, companies use their existing equity base to borrow funds, instead of issuing new shares.
• Investing borrowed funds: It allows the companies to invest the borrowed money in new projects or assets, with an aim to earn higher returns than the cost of borrowing.
• Earnings for shareholders: When the investments are successful and the returns are higher than the interest paid on the debt, the extra profit increases the earnings per share (EPS) for the shareholders.

Types of Trading on Equity

There types of trading on equity is based on the capital structure of a company. Let’s quickly discuss them!

• Trading on Thin Equity: This involves using a larger amount of borrowed funds compared to the company’s equity capital, making it a high-leverage strategy where the debt is higher than the equity. For example, Adani Power Ltd. uses high debt to fund large projects, where borrowed funds exceed its equity base.
• Trading on Thick Equity: This involves using more of a company’s equity than borrowed funds, making it a lower-leverage strategy where the equity is greater than the debt. For example, Infosys Ltd. relies on its capital with minimal debt, showing a low-leverage, stable trading on a thick equity model.

Benefits of Trading on Equity

Here are the main benefits trading on equity provides to the company and its shareholders:

• Funding for growth: Trading on equity lets the companies borrow funds for making investments into new projects or expansions by leveraging their equity base.
• Ownership control: It provides the companies a base to raise funds through debt instead of issuing new shares, which prevents the existing owners from losing ownership.
• Tax shield: The interest on the borrowed funds is tax-deductible, which lowers the taxable income and overall tax liability for the companies.
• Enhanced returns: When the company’s debt investments generate higher returns, it increases the earnings per share (EPS) for the shareholders.

Risks and Considerations of Trading on Equity

• Financial Risk: When a company takes debt to trade on equity, it increases financial risk, meaning if returns are lower than the interest on debt, the company might face financial stress.
• Interest Rate Fluctuations: A rise in the interest rates might increase the cost of debt for the company, which makes it harder to manage. It might even turn a once-profitable project into a loss.
• Credit Rating Impact: When a company indulges in excessive debt, it can negatively affect a company’s credibility, making future borrowing difficult or expensive.
• Over-Leverage: The over-reliance on debt can reduce shareholders’ confidence and increase the risk of losses, particularly if short-term borrowings are used. 

Real-World Examples

• Reliance Industries Ltd.: In 2022, Reliance Industries issued $4 billion in foreign currency bonds, which is India’s largest-ever issue of this type, backed by a healthy balance sheet and a high credit rating. This low-cost borrowing has helped Reliance to fund its projects across the telecom, retail, and renewable energy sectors.
• Tega Industries Ltd: Tega Industries is planning to raise ₹3,300 Cr to acquire a majority stake in the US-based Molycop, with ₹2,300 Cr as equity and ₹1,000 Cr as debt. This move highlights how a well-built equity foundation can help companies balance funding sources.

Conclusion: Is Trading on Equity Right for You?

Trading on equity, when managed wisely, can be a smart strategy. It helps companies to grow faster without giving up ownership. However,  it also adds financial pressure if the returns fall short.

For the investors, the key is to choose such companies that use their debt strategically, while balancing their goals with stability and delivering consistent long-term returns.

FAQ‘s