What is Trading on Equity?

What if you want to buy a house and it costs Rs.50 Lakh, but you only have Rs.10 Lakhs in savings and you really want to buy it. What would you do, you walk into a bank, use your Rs.10 lakh as a down payment; this is your ‘equity’, and you take a loan for the remaining Rs.40 lakh. 

Now, after a year and half, the value of your house rises up by 10% to Rs.55 lakh, giving you Rs.5 lakh profit. But look, you only invested Rs.10 lakh of your own money. So, on your personal investment, you’ve made a good 50% return (Rs.5 lakh profit/Rs.10 lakh investment). This magnifying effect is the superpower of using borrowed money also known as leverage in the stock market.

The big companies that you invest in also use the exact same, when a company uses borrowed money to boost profits for its owners (the shareholders, like you), it’s called trading on equity.

What is Trading on Equity?

Trading on Equity is a financial strategy where a company uses borrowed funds, like loans from banks or money raised by issuing debentures to investors, to buy assets or fund new projects.   

The goal here is simple to earn a higher rate of return from these new investments than the interest rate it has to pay on the borrowed money. Any extra profit made goes directly to the shareholders, increasing their earnings. This method is also famously known as ‘financial leverage’.   

It doesn’t mean the company is trading its own shares. Instead, it means the company is using its existing equity, the money invested by the owners acting as a strong base or foundation to get these loans. Lenders are more willing to give money to a company that has a solid financial hold, which comes from its equity.   

How does Trading on Equity work?

Harjyot Textiles is doing well and wants to open a new factory to expand its business. It needs Rs.20 lakh for this. The company’s owners (shareholders) have already put in Rs.10 lakh, which is its current equity capital (10,000 shares worth Rs.100 each).

The company expects the new factory to earn a profit of Rs. 4 lakh every year before paying interest and taxes (this is called EBIT). The tax rate is 30% now, the management has two main options to raise the extra Rs.10 lakh.

Option 1 : Use Only Equity, the company can ask its existing owners or new investors for fulfillment of  Rs.10 lakh by issuing 10,000 new shares.

Option 2 : Use Debt (Trading on Equity), the company can borrow the entire Rs.10 lakh from a bank at a 10% interest rate.

Let’s see how your earnings as a shareholder change in both scenarios. We will look at a key metric called Earnings Per Share (EPS), which tells you how much profit the company makes for each share.   

Particulars	All Equity	All Debt
Earnings Before Interest & Tax (EBIT)	₹4,00,000	₹4,00,000
Interest on Loan	₹0	₹1,00,000 (10% of ₹10 lakh)
Earnings Before Tax (EBT)	₹4,00,000	₹3,00,000
Tax @ 30%	₹1,20,000	₹90,000
Earnings for Shareholders	₹2,80,000	₹2,10,000
Number of Shares	20,000 (10k old + 10k new)	10,000 (Only old shares)
Earnings Per Share (EPS)	₹14.00 (2,80,000/20,000)	₹21.00 (2,10,000/10,000)

Even though the total profit for shareholders was lower in Option 2 (because of the interest payment), your earning per share jumped from Rs.14 to Rs.21. This happened because the profit was shared among fewer shares. This is trading on equity working its magic.   

But remember, this is a double-edged sword. What if the new factory doesn’t do well and only makes an EBIT of Rs.50,000, then

Particulars	All Equity	All Debt
Earnings Before Interest & Tax (EBIT)	₹50,000	₹50,000
Less: Interest on Loan	₹0	₹1,00,000 (10% of ₹10 lakh)
Earnings Before Tax (EBT)	₹50,000	– ₹50,000 (Loss)
Less: Tax @ 30%	₹15,000	₹0 (No Tax on losses)
Earnings for Shareholders	₹35,000	– ₹50,000 (Loss)
Number of Shares	20,000	10,000
Earnings Per Share (EPS)	₹1.75	– ₹5.00

When things went bad, the debt magnified the losses. Your EPS crashed to a loss of Rs.5, while with the all-equity option, you still made a small profit. This is the risk that comes with this strategy.

Read Also: Equity Shares: Definition, Advantages, and Disadvantages

Types of Trading on equity 

Companies can decide how much risk they want to take. This choice leads to two different styles or types of trading on equity.   

1. Trading on Thin Equity

This is the high-risk, high-reward approach. A company is said to be trading on thin equity when its borrowed money (debt) is much higher than its own money (equity).   

• Imagine a company that has Rs.20 crore of its own equity but has taken loans worth Rs.80 crore. This company is heavily reliant on debt.
• This is common for companies that need a lot of money to expand, like infrastructure or new-age technology companies. They are betting big on future growth.   

2. Trading on Thick Equity

This is the safe, conservative approach. A company is trading on thick equity when it uses more of its own funds and has a relatively small amount of debt.   

• A company with Rs.80 crore of its own equity and only Rs.20 crore in loans is trading on thick equity.
• This is often seen in stable, mature companies that value financial strength and have predictable earnings. They are not chasing instant growth but prefer stability.   

Advantages and Disadvantages of Trading on Equity

Advantages of Trading on Equity

1. Higher Returns : As the above mentioned example showed, when a company succeeds, this strategy can significantly boost the Earnings Per Share (EPS). This makes your shares more profitable and can lead to a higher share price.   
2. Saves Tax : The interest paid by a company on its loans is considered a business expense. This means it can be deducted from the earnings before tax is calculated. This lowers the company’s tax bill, leaving more money for growth.   
3. Owners Control : When a company raises money by taking a loan, it doesn’t have to issue new shares. This means the existing owners don’t see their ownership percentage get smaller and they keep full control of the company.   
4. Faster Growth : This strategy gives companies access to large amounts of money to fund big projects, buy other companies, or expand much faster than they could using only their own funds.   
5. Increase Share Price : A company that uses debt wisely to grow its profits and EPS is often rewarded by the stock market. A higher EPS can lead to a higher share price, increasing the value of your investment.   

Disadvantages of Trading on Equity

1. Bigger Losses : Just as profits are high, losses are too. If an investment fails, the company still has to pay back the entire loan with interest, which can wipe out shareholder profits.   
2. Fixed Interest Payments : A loan’s interest payment is a fixed cost. It must be paid every month or year, whether the company is making profits or not. During a bad year, this can put a huge strain on the company’s finances.   
3. Risk of Bankruptcy : If a company is unable to make its interest payments for too long, the lenders can take legal action and force the company into bankruptcy. In this case, shareholders are last in line to get paid and can lose their entire investment.   
4. Unpredictable Earnings : A company with high debt is more vulnerable to economic shocks. A small dip in sales can cause a huge drop in profits and the share price, making the stock much riskier and more volatile.   
5. Future Loans : A company that is already loaded with debt (trading on thin equity) might find it very difficult to get more loans in the future. Banks may see it as too risky, limiting the company’s ability to raise funds when it needs them.   

Difference between Trading on Equity and Equity trading 

This is a very common point of confusion, so let’s make it crystal clear. The two terms sound almost the same, but they are completely different worlds.   

Trading on Equity is a strategic decision made inside a company’s boardroom, where the company’s management uses borrowed money (like loans) to fund projects, aiming to earn more than the interest on the loan and thereby boost profits for its shareholders.   

On the other hand, Equity Trading is simply the act of buying and selling shares of companies in the stock market, with the goal of making a profit from the changes in the stock’s price.   

One is a corporate financing strategy, while the other is a market investment activity.

Conclusion

As an investor, it’s important to assess whether a company is using trading on equity and how aggressively it is doing so. This insight is a crucial part of your research, as it reveals the real risks behind your investment. A company with high debt isn’t necessarily a bad choice, just as one with low debt isn’t automatically safe. What truly matters is the company’s ability to remain financially stable and generate sufficient profits to comfortably meet its obligations.

S.NO.	Check Out These Interesting Posts You Might Enjoy!
1	Types of Traders in the Stock Market: Styles, Strategies & Pros and Cons
2	How to Start Stock Market Trading With Low or Limited Capital
3	Different Types of Trading in the Stock Market
4	Margin Against Shares: How Does it Work?
5	What Is Day Trading and How to Start With It?