For a company to grow and become profitable, it needs a lot of capital. Trading on equity is one of the many financial strategies that companies use to gain access to funds. Furthermore, there are two different types of trading on equity that most companies employ – trading on thin equity and trading on thick equity. Wish to know more about this unique financial strategy? Continue reading to find out.
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What is Trading on Equity
Also known as financial leverage, trading on equity is a strategy that involves taking on debt to enhance the profits of the company and ultimately the returns to shareholders.
A company may choose to take on debt through term loans, bonds, debentures or preference share issues. The funds that the company borrows are used to purchase assets that can generate returns or help the company earn more revenue.
For trading on equity to be successful, the company employing the strategy must generate more revenue than the overall cost of borrowing.
Let’s take a quick look at a hypothetical example to better understand this unique financial concept.
Assume there’s a company A with a total equity of ₹50 crores. The company decides to borrow funds to the tune of ₹20 crores by issuing debentures. The rate of interest on the debentures is 12% per annum. The company plans to use the borrowed funds (₹20 crores) to purchase a few assets that would help it generate more income, boost profitability and enhance the returns to its shareholders.
Now, the interest cost on the borrowed funds comes up to about ₹2.40 crores per annum (₹20 crores x 12%). Thanks to the efficient use of the borrowed funds, the company’s revenue has increased by about ₹3 crores per annum. Since the revenue earned by it is more than the cost of the borrowed funds, the company’s trading on equity strategy is successful.
What are the Different Types of Trading on Equity?
Trading on equity can be classified into two types – trading on thin equity and trading on thick equity. Here’s a closer look at each of these two types.
- Trading on Thin Equity
If the debt capital of a company is higher than its equity capital, it is said to be trading on thin equity. For instance, if the borrowed funds are ₹50 crores and its equity share capital is ₹45 crores, then the company is said to be trading on thin equity.
- Trading on Thick Equity
On the contrary, if the debt capital of a company is lower than its equity capital, it is said to be trading on thick equity. In the first example, the company’s debt capital was just ₹20 crores, whereas its equity capital was ₹50 crores. This is a classic case of a company trading on thick equity.
What are the Advantages of Trading on Equity?
A company that uses the trading on equity strategy gets to enjoy a host of different benefits. Here’s a quick overview of some of the key advantages.
- Improved Revenues
As you’ve already seen, the primary purpose of the trading on equity strategy is to enable companies to generate more revenue. When executed right, a company can significantly enhance the revenues, profits and ultimately the returns to the investors.
- Tax Benefits
Another major advantage of trading on equity is the tax benefit that it offers. The interest cost on borrowed funds is a tax-deductible expense. This effectively means that the company can lower its total taxable income by claiming the interest paid on the borrowed amount as a deduction. This will help lower the amount of taxes that it has to pay to the government.
- Prevents Dilution of Ownership
For companies, there are two types of funding options available – equity financing and debt financing. Equity financing involves the issue of equity shares to the public in exchange for funds.
Though this method of financing may be more cost-effective than debt, it will dilute the ownership and control of the company since it will lead to more equity shares in circulation. Debt financing, on the other hand, will not cause any such dilution of ownership. The company will get to retain control over its business operations as it is. This is one of the primary reasons why trading on equity is widely preferred.
What are the Disadvantages of Trading on Equity?
Trading on equity also has a few drawbacks. Let’s take a look at some of the most important disadvantages of this financial strategy.
- Increase in Financial Burden
With trading on equity, the company has to regularly service the debt by paying interest to the borrowers. If the borrowed amount is high, the interest payouts alone can increase the company’s financial burden significantly. Furthermore, if there’s any unexpected rise in interest rates, the company may have to pay additional interest on its loans.
- Bankruptcy
If a company is breaking even or under a slight loss, opting for the trading on equity strategy can end up deepening its losses. Sustained periods of losses may even lead the business toward bankruptcy.
Conclusion
With this, you must now be well-versed in the meaning of trading on equity. Many Indian companies routinely use this strategy as a means to enhance their revenue and profitability. However, it is a double-edged sword and can also lead to deep losses if the company fails to generate more revenue than the overall cost of borrowing.
