Trading on Equity

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Trading on Equity?

Trading on equity refers to the corporate action in which a company raises more debt to boost the return on investment for the equity shareholders. This process of financial leverage is considered a success if the company can earn a greater ROI. On the other hand, if the company cannot generate a rate of return higher than the cost of debt, then the equity shareholders end up earning much lower returns.

Key Takeaways

  • Trading on equity means the corporate action in which a company raises more debt to enhance the return on investment for the equity shareholders. 
  • The types of trading on equity are trading on thin equity and thick equity.
  • The advantage of equity trading is that a company may earn higher revenue by purchasing assets using borrowed money. Also, it lowers the borrower’s tax burden as the interest paid on debt is tax-deductible. 
  • The disadvantages of a trading name are that their unstable income or volatile profits may adversely affect the shareholder’s return. In addition, it sometimes results in the borrowing entity’s overcapitalization. 

Types of Trading on Equity

Based on the size of debt funding relative to available equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.read more, it is classified into two types: –

Trading on Equity

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Source: Trading on Equity (wallstreetmojo.com)

  1. Trading on Thin Equity: If the equity capital of a company is lesser than the debt capital, it is known as trading on thin equity. In other words, the share of debt (such as bank loans, debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more, bonds, etc.) is higher than equity in the overall capital structure. Trading on thin equity is also known as small or low equity trading.
  2. Trading on Thick Equity: If the equity capital of a company is more than the debt capital, then it is known as trading on thick equity. In other words, the equity share is higher than that of debt in the overall capital structureCapital StructureCapital Structure is the composition of company’s sources of funds, which is a mix of owner’s capital (equity) and loan (debt) from outsiders and is used to finance its overall operations and investment activities.read more. Trading on thick equity is also known as trading on high equity.

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Examples

Let us understand with examples.

You can download this Trading on Equity Excel Template here – Trading on Equity Excel Template

Example #1

Let us take the example of ABC Inc. to illustrate the impact of trading on thick equity on shareholder return. Let us assume that the company infused $2,000,000 of equity capital and raised $500,000 of bank debt to acquire a new factory. Determine the rate of returnRate Of ReturnRate of Return (ROR) refers to the expected return on investment (gain or loss) & it is expressed as a percentage. You can calculate this by, ROR = {(Current Investment Value – Original Investment Value)/Original Investment Value} * 100read more for the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more assuming the cost of debt Cost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more to be 5% and that there is no income tax if the factory is expected to generate an annual profit of: –

  1. $250,000
  2. $50,000
Given Data

Therefore, one can calculate the rate of return for shareholders as,

Rate of Return for Shareholders = (Profit – Debt * Cost of Debt) / Equity

Trading on Equity Example 1-1
  • = ($250,000 – $500,000 * 5%) / $2,000,000
  • = 11.25%

Therefore, the shareholders earn a rate of return of 11.25%.

Trading on Equity Example 1-2

Therefore, one can calculate the rate of return for shareholders as,

Rate of Return for Shareholders = (Profit – Debt * Cost of Debt) / Equity

Trading on Equity example 1-3
  • = ($50,000 – $500,000 * 5%) / $2,000,000
  • = 1.25%

Therefore, the shareholders earn a rate of return of 1.25%.

Example #2

Let us take the above example again and illustrate the impact of trading on thin equity on shareholder returnShareholder ReturnTotal Shareholder Return (TSR) is a percentage indicator of the performance of the stock return over the time it is held. The return includes capital appreciation and the dividend earned on the stock. TSR = Current Price – Purchase Price + Dividend / Purchase Price read more. Let us assume that the company raised $2,000,000 of debt and infused only $500,000 of equity to acquire the factory. Determine the rate of return for the shareholders taking the cost of debt to be 5% and that there is no income tax if the factory is expected to generate an annual profit of: –

  1. $250,000
  2. $50,000
Data

Therefore, one can calculate the rate of return for shareholders as,

Rate of Return for Shareholders = (Profit – Debt * Cost of debt) / Equity

Trading on Equity Example 2-2
  • = ($250,000 – $2,000,000 * 5%) / $500,000
  • = 30.00%

Therefore, the shareholders earn a rate of return of 30.00%.

Trading on Equity Example 2-3

Therefore, one can calculate the rate of return for shareholders as,

Rate of Return for Shareholders = (Profit – Debt * Cost of Debt) / Equity

Result
  • = ($50,000 – $2,000,000 * 5%) / $500,000
  • = -10.00%

Therefore, the shareholders incurred a loss of -10.00%.

Effects

The examples illustrated in the previous section show that equity trading is like a lever that magnifies the impact of variations in earnings. As a result, the effect of fluctuation in earnings is stretched on the rate of return earned by the shareholders. Further, the variation in the rate of return is higher in the case of trading on thin equity than in trading on thick equity.

Advantages

  • A company can earn higher revenue by purchasing new assets using borrowed money.
  • Since the interest paid on debt is tax-deductible, it lowers the borrower’s tax burden.

Disadvantages

Frequently Asked Questions ( FAQs)

What does trading on equity do?

Trading on equity uses fixed-cost sources of finance like preference shares, debentures, and long-term loans in the capital structure to boost the return on equity shares. It is also known as financial leverage.

When do we use trading on equity?

Equity trading occurs when a company incurs new debt utilizing bonds, loans, bonds, or preferred stock. The company uses these funds to get assets, making returns more considerable than the new debt interest. Preferably, trading on equity is called financial leverage.

Is trading on equity financial leverage?

Yes, equity trading is a form of financial leverage. However, using economic leverage increases the risk of losses, as investors are responsible for paying back the borrowed funds and the associated interest costs.

Trading on equity means the use of which capital?

Trading on equity means the use of borrowed capital for funding a firm.

Recommended Articles

This article is a guide to what is Trading on Equity and its meaning. We discuss types, effects, advantages, disadvantages, and trading on equity example here. You may learn more about financing from the following articles: –