Explain the term Trading on Equity with the help of an example.

Answer – Trading on equity uses debt carrying a fixed financial charge to increase earnings available per equity share when the return on investment exceeds the cost of debt. It can also magnify losses, so it is not an assured gain.

Example, ignoring tax: a business needs ₹10,00,000 and earns EBIT of ₹2,00,000. With all-equity finance and 10,000 shares, EPS is ₹20. If ₹5,00,000 is borrowed at 10% and equity is reduced to 5,000 shares, interest is ₹50,000 and EPS becomes ₹1,50,000 ÷ 5,000 = ₹30. The 20% operating return exceeds the 10% debt cost.

If EBIT falls to ₹50,000, the same interest absorbs the entire amount and EPS becomes zero. Debt therefore increases both possible return and financial risk.