In the world of business money management, every company tries to make the most of what its owners invest and improve how much money is earned from that investment. One strong method companies use to do this is called Trading on Equity, or Financial Leverage. This approach lets businesses use money they borrow to increase the returns they give to the people who own the company. Although this can lead to bigger profits, it also has risks that need to be handled carefully.
In this blog, we will explain what Trading on Equity means, the advantages it offers, and how it affects returns, using examples to show how it works in real-life business situations.
What Is Trading on Equity?Trading on equity is when a company uses borrowed money, such as loans or bonds, to make profits higher for the people who own shares in the company. Equity means the ownership stake that shareholders have, and trading here means using borrowed funds to improve returns. The company takes advantage of debt to boost the profits that go to the equity shareholders.
How Trading on Equity WorksTo understand how trading on equity works, consider this:
- A company can fund its operations using either equity or debt.
- Debt carries fixed interest obligations.
- If the company makes more money than the cost of its debt, the extra profit increases the return for equity investors.
This difference is known as the spread.
Key Formula: Financial Leverage Effect = Return on Investment (ROI) - Cost of Debt - If ROI > Cost of Debt ? Favorable financial leverage
- If ROI < Cost of Debt ? Unfavorable financial leverage
Example of Trading on EquitySuppose a company needs ?10,00,000 for expansion. Case 1: Fully Equity Funded - Equity: Rs 10,00,000
- ROI: 15% = Rs1,50,000
- Interest cost: NIL
- Net Profit: Rs1,50,000
- Return on Equity (ROE): 15%
Case 2: Mix of Debt & Equity - Equity: Rs5,00,000
- Debt: Rs5,00,000 at 8% interest
- Total ROI: Rs1,50,000
- Interest on debt: Rs40,000
- Net Profit: Rs1,10,000
Now, ROE = Rs1,10,000 / Rs5,00,000 = 22% ROE increased from 15% to 22% with the use of debt. This is the power of trading on equity.
Benefits of Trading on EquityTrading using equity gives businesses several benefits when they want to grow in a smart way. Here are the main advantages:
1. Enhances Return on EquityThe biggest benefit is that shareholders get higher returns. When using debt in a smart way, the profits for stock owners grow more quickly than they would if the company only used equity financing.
2. Helps Businesses Expand Without Diluting OwnershipBy using debt instead of issuing more shares, businesses can:
- Maintain control
- Prevent ownership dilution
- Boost earnings per share (EPS)
This especially benefits founders and early investors.
3. Lower Cost of CapitalDebt is often cheaper than equity because:
- Interest is a fixed cost
- Interest payments are tax-deductible, reducing the effective cost
This lowers the company`s weighted average cost of capital (WACC), which makes its projects more profitable.
4. Improves Market PerceptionA company that efficiently uses leverage is often seen as:
- Financially disciplined
- Growth-oriented
- Capable of generating high returns
This can improve stock market valuation and investor confidence.
5. Tax BenefitsInterest on money borrowed is allowed to be subtracted from taxes, but payments made to shareholders as dividends are not. This means using debt to get money is better for tax purposes, which makes the company`s profit after taxes higher.
Risks & Limitations of Trading on EquityWhile trading on equity can be beneficial, it must be used cautiously. Here are the key risks:
1. Increased Financial RiskTaking on debt means you have to keep paying interest regularly, even if your business isn`t making a profit. If earnings decline, the company may face:
- Cash flow issues
- Default risk
- Financial instability
2. Possibility of Unfavorable LeverageIf ROI drops below the cost of debt, then:
- ROE decreases
- Losses escalate
- Shareholder value gets affected
This is known as negative financial leverage.
3. Restrictive Debt CovenantsLoans and debentures often come with conditions such as:
- Maintaining specific financial ratios
- Restrictions on additional borrowing
- Limits on dividend payouts
These may restrict managerial flexibility.
4. Increased Bankruptcy RiskOver-leveraging can push a company toward insolvency, especially during:
- Economic slowdowns
- Industry downturns
- Sudden revenue drops
Thus, improper use of trading on equity can be dangerous.
When Should Businesses Use Trading on Equity?Companies should consider using leverage when:
1. ROI is consistently higher than borrowing costsA stable and predictable earnings environment makes leverage safer.
2. The business operates in a low-risk industryIndustries like utilities and FMCG with steady cash flows are ideal.
3. The company requires funds for expansionDebt is often used to finance: New branches Machinery Technology upgrades Marketing campaigns
4. Management has strong control over expensesEfficient cost management increases the chances of generating positive leverage.
Impact of Trading on Equity on ReturnsTrading on equity directly affects three major financial indicators:
1. Return on Equity (ROE)ROE increases if the leverage is favorable. This boosts investor satisfaction and market valuation.
2. Earnings per Share (EPS)With debt financing, profits are shared among the same number of shareholders, increasing EPS-provided the company earns more than interest costs.
3. Market Value of SharesHigher ROE and EPS often lead to: Greater investor interest Higher share demand Increased share prices
Thus, effective trading on equity can significantly enhance a company`s market capitalization.
ConclusionTrading on equity, also called financial leverage, is a strategy that lets companies increase returns for shareholders by using borrowed money. When used correctly, especially in businesses that are stable and making profits, it can greatly raise return on equity, earnings per share, and overall growth. But it also brings financial risks, so it needs careful planning and ongoing monitoring to manage properly.
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Posted on: 10-Dec-2025 | Posted by: NIFM |
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