Trading on Equity: Meaning, Types and Example

Trading on equity is a familiar concept in corporate finance, especially for companies aiming to expand without diluting ownership. It plays a key role in how organisations structure their capital and manage growth. When used well, it can improve returns for shareholders. When overused, it can increase financial risk. This blog explains the meaning, types, advantages, disadvantages and a simple example to help you understand how it works.

What is Trading on Equity?

Trading on equity refers to the practice of using debt to increase the return on equity for shareholders. The idea is straightforward. When a company borrows money at a cost lower than the returns it can generate from that money, the excess return benefits equity holders.

It is also known as financial leverage. Companies adopt this method when they believe that borrowed funds can help them expand operations, improve revenue or take advantage of growth opportunities without issuing new shares.

In simple terms, trading on equity amplifies profits for shareholders by using debt wisely. However, it can also magnify losses if earnings fall.

Types of Trading on Equity

• Favourable Trading on Equity

This occurs when a company’s return on investment is higher than the interest it pays on borrowed funds. For example, if a firm earns 15 percent on capital but pays only 10 percent as interest, shareholders gain from the difference.

• Unfavourable Trading on Equity

This happens when the company’s return on investment falls below the interest cost. For instance, if it earns 8 percent but pays 10 percent as interest, the negative gap reduces shareholder returns.

• High Leverage

A company with a high proportion of debt in its capital structure is considered highly leveraged. This can lead to higher returns during strong business conditions but also increases the risk during downturns.

• Low Leverage

Here, the company borrows very little. Risk is lower, but the potential benefit of using low-cost debt is limited.

Advantages of Trading on Equity

• Higher Return on Equity

If the company earns more than the cost of borrowing, the surplus boosts shareholder returns. This makes the firm more attractive to investors.

• Access to Low-Cost Capital

Debt is usually cheaper than equity financing. Interest paid on loans is also tax-deductible, reducing the overall cost of funds.

• No Dilution of Ownership

Raising equity means sharing ownership. Debt financing allows companies to grow without giving up control.

• Supports Expansion

Borrowed funds can be used to scale operations, upgrade technology or enter new markets, helping the business grow faster.

• Improved Market Reputation

Strong companies that use leverage effectively often build credibility with lenders, making future borrowing easier.

Disadvantages of Trading On Equity

• Higher Financial Risk

More debt means larger fixed interest obligations. If earnings fall, meeting these payments becomes difficult.

• Pressure on Cash Flow

Interest and principal repayments can strain the company’s cash flow, especially during slow business periods.

• Possibility of Default

Excessive leverage increases the risk of default, which could damage the company's credit rating and long-term stability.

• Lower Flexibility

Heavy debt limits a company’s ability to borrow in the future. Lenders may impose strict conditions or covenants.

• Impact on Shareholder Value

If trading on equity becomes unfavourable due to declining returns, shareholders may face reduced earnings and lower share prices.

Difference between Trading on Equity and Equity Trading

Example of Trading on Equity

Consider a company named ABC Ltd.

• Shareholder’s equity: ₹50 lakh

• Debt borrowed: ₹30 lakh at 10 percent interest

• Total capital: ₹80 lakh

• Profit before interest: ₹16 lakh

Step 1: Calculate interest
Interest on debt = ₹30 lakh × 10 percent = ₹3 lakh

Step 2: Profit after interest
Profit after interest = ₹16 lakh minus ₹3 lakh = ₹13 lakh

Step 3: Return on Equity (ROE)
ROE = ₹13 lakh ÷ ₹50 lakh = 26 percent

If the company had not borrowed funds, its total capital would be only ₹50 lakh. Assume it earns 20 percent on equity without leverage.

Profit without leverage = ₹50 lakh × 20 percent = ₹10 lakh
ROE = 20 percent

By using debt, the ROE increased from 20 percent to 26 percent, showing how trading on equity can benefit shareholders when returns exceed the cost of borrowing.

Conclusion

Trading on equity is a powerful financial tool that helps companies enhance shareholder returns by using debt effectively. When the returns generated from borrowed funds exceed the cost of interest, shareholders benefit through higher earnings. However, the strategy demands careful planning since excessive leverage can increase financial risk. For businesses with stable revenues and strong financial discipline, trading on equity can support long-term growth without diluting ownership.