Trading on equity, also known as financial leverage, refers to the practice of using borrowed funds or debt to finance the assets of a company in order to increase shareholder’s equity. It involves using debt capital to increase the returns on equity investments. When a company has a higher proportion of debt in its capital structure, it is said to be trading on equity.
Importance of trading on equity:
- Enhanced returns: Trading on equity can help increase the return on equity by using borrowed funds at a lower cost than the returns generated from investments.
- Tax benefits: Interest payments on debt are tax-deductible, which can lead to lower taxable income and increased profitability.
- Capital optimization: Companies can optimize their capital structure by striking a balance between debt and equity, maximizing shareholder value.
Types of trading on equity:
- Positive trading on equity: Occurs when a company’s return on investment (ROI) is higher than the cost of debt, leading to increased returns for equity shareholders.
- Negative trading on equity: Occurs when the company’s ROI is lower than the cost of debt, leading to a decrease in returns for equity shareholders.
Formula for trading on equity: Trading on equity can be analyzed using the following formula: Degree of Financial Leverage (DFL) = (Earnings Before Interest and Taxes (EBIT) / Earnings Before Taxes (EBT))
Examples of trading on equity:
- A company issues bonds at an interest rate of 5% and invests the proceeds in a project that generates a return of 10%. In this case, the company is positively trading on equity, as the return on investment exceeds the cost of debt.
- A company borrows funds at an interest rate of 8% but invests in a project that yields only a 6% return. In this case, the company is negatively trading on equity, as the cost of debt is higher than the return on investment.
Issues and limitations of trading on equity:
- Increased financial risk: A higher level of debt can lead to increased financial risk, as the company must meet its interest payment obligations even during periods of low profitability.
- Limited flexibility: High debt levels can restrict a company’s ability to take on new debt for future growth or respond to financial difficulties.
- Credit rating: Excessive debt may lead to a lower credit rating, increasing the cost of borrowing in the future.
- Potential dilution of ownership: If a company is unable to meet its debt obligations, it may have to issue additional equity, diluting the ownership of existing shareholders.
- Bankruptcy risk: Companies that are highly leveraged may face a higher risk of bankruptcy if they are unable to meet their debt obligations.