Borrowed Capital: Advantages, Risks, and the Concept of Trading on Equity

Every growing business eventually faces the same question: where will the money come from? Owners can put in their own funds, but personal savings have limits. This is where borrowed capital enters the picture. It allows a company to access large sums for expansion, machinery, or working capital without diluting ownership. But borrowing is a double-edged sword. The same money that can multiply profits can also push a firm into serious trouble when the business slows down. Understanding how borrowed capital works, and the powerful idea of trading on equity, is essential for anyone studying how businesses are financed.

What is borrowed capital? 🔗

Borrowed capital refers to the funds a business raises through loans, debentures, or bonds rather than from its owners. The people who provide this money are creditors, not owners. They do not get a share in profits or any voting rights. Instead, they are promised two things: regular interest at a fixed rate, and repayment of the principal amount on agreed terms.

These instruments are part of what the financial world calls debt instruments or fixed-income securities. The defining feature is certainty for the lender. A debenture holder who lends ₹10,000 at 12% knows exactly what return to expect, regardless of whether the company earns huge profits or barely breaks even.

The most common forms of borrowed capital are term loans from banks and financial institutions, debentures, and bonds. A debenture is essentially an acknowledgement of debt issued by a company under its seal, setting out the rate of interest and the terms of repayment. Bonds work on a similar principle and are often issued by government bodies and large corporations.

Borrowed capital versus owned capital 🔗

The contrast between borrowed and owned capital is the heart of this topic. Owned capital comes from shareholders. It carries no fixed repayment burden, dividends are paid only when profits allow, and shareholders share in both the rewards and the risks of ownership. Borrowed capital is the opposite. Interest must be paid whether or not the company makes a profit, and the principal must be returned on a fixed date.

Because of this fixed obligation, borrowed capital is often described as temporary capital. It sits on the company’s books for a defined period and then leaves once repaid. Owned capital, by contrast, stays with the business for its lifetime.

The fixed burden of interest and repayment 🔗

The single most important feature of borrowed capital is that interest is a fixed charge. It is a contractual commitment, not a discretionary payment. A company that has issued ₹1 crore of debentures at 11% must pay ₹11 lakh in interest every year, even in a year when it earns nothing.

This is very different from a dividend. If a company has a bad year, it can simply skip the dividend on equity shares and no law is broken. But skipping interest on borrowed capital is a default, and the consequences are severe.

What happens when a company cannot pay? 🔗

Failure to pay interest or repay principal damages a company’s creditworthiness almost immediately. Credit rating agencies downgrade it, future borrowing becomes more expensive or impossible, and suppliers may demand advance payment. Beyond reputation, there are legal consequences. Creditors can take the company to court, and in the case of secured borrowing, they can enforce their claim against the assets pledged to them.

Indian law builds in protections for lenders. Under the Companies Act, 2013, when a company issues debentures it is generally required to create a Debenture Redemption Reserve out of its profits, money that can only be used to repay debenture holders. For secured debentures, a charge is created over the company’s assets and a debenture trustee is appointed to protect the interests of the lenders. These rules exist precisely because the repayment promise behind borrowed capital is taken so seriously.

Types of debentures a company can issue 🔗

Debentures come in several varieties, and the classification matters for both the company and the investor.

Secured and unsecured: Secured debentures are backed by a charge on the company’s assets, so lenders have something to fall back on if the company defaults. Unsecured debentures rely only on the general creditworthiness of the issuer. Under Indian rules, secured debentures generally cannot be issued for a period exceeding ten years, though certain infrastructure companies are allowed longer tenures.

Redeemable and irredeemable: Redeemable debentures are repaid on a fixed maturity date. Irredeemable debentures have no fixed repayment date and may remain outstanding for a very long time.

Convertible and non-convertible: Convertible debentures can be exchanged for equity shares after a certain period, turning a creditor into an owner. Non-convertible debentures remain debt throughout their life.

The big advantage: trading on equity 🔗

Now we reach the most interesting reason businesses borrow. When a company earns more on the borrowed money than it pays in interest, the surplus belongs entirely to the owners. This magnifying effect is called trading on equity, also known as financial leverage.

The logic is straightforward. Interest is a fixed cost. Once it is paid, every additional rupee of profit flows to the shareholders. So if a business can earn a higher rate of return than the rate of interest it pays, the owners’ return on their own money rises above what they could have achieved on their own. As one accounting reference puts it, trading on equity lets a firm earn a disproportionate return on its assets when debt financing is used.

A worked example 🔗

Consider a business that needs ₹1,00,000 in total. Suppose the owners contribute ₹40,000 of their own money and borrow the remaining ₹60,000 as a loan at 15% interest. The business earns a profit of ₹30,000 before paying interest.

First, the interest cost: 15% of ₹60,000 equals ₹9,000. After paying this, the owners are left with ₹30,000 minus ₹9,000, which is ₹21,000. Their own investment was only ₹40,000, so their return is ₹21,000 divided by ₹40,000, which works out to 52.5%.

Now compare this with a situation where the owners did not borrow at all and instead funded the entire ₹1,00,000 from their own pockets. The same profit of ₹30,000 on ₹1,00,000 of owned capital gives a return of just 30%.

The difference is striking. By borrowing at 15% and earning more than that on the project, the owners pushed their personal return from 30% up to 52.5%. They did not work harder or sell more. They simply used borrowed money that cost less than what the business earned, and kept the difference. This is the power of trading on equity in action.

There is a second benefit worth noting. In many tax systems, including India’s, interest expense is tax deductible, which lowers the effective cost of borrowing. Dividends paid to shareholders enjoy no such deduction. This tax advantage makes debt even more attractive when used wisely.

The hidden risk when profits decline 🔗

The same leverage that multiplies gains also multiplies losses. The fixed interest charge does not shrink just because business is bad. This is the danger that every borrowing company must respect.

Return to the earlier example, but imagine the business earns only ₹6,000 in a tough year instead of ₹30,000. The interest of ₹9,000 still has to be paid. Now the owners are not earning a surplus at all. They are short by ₹3,000, which they must cover from their own funds or other reserves. Had they used only their own capital, a ₹6,000 profit would still have been a modest positive return. Borrowing turned a small profit into a loss for the owners.

This is why financial leverage is described as a strategy that amplifies returns when earnings exceed the cost of debt but magnifies losses when earnings fall short. Companies with stable, predictable income can carry more debt comfortably. Businesses with volatile or seasonal earnings face a much higher chance that interest will swallow their profits.

Thin equity and thick equity 🔗

Analysts describe a company’s borrowing posture using two terms. Trading on thin equity means the firm has a small amount of owned capital compared with a large amount of borrowed capital. This setup offers the highest potential rewards but also the greatest risk. Trading on thick equity means owned capital is large relative to debt, which is safer but offers less amplification of returns. A company with ₹250 crore in equity but ₹600 crore in debt would be considered to be trading on thin equity because borrowed funds dominate its structure.

Excessive reliance on borrowed capital can also push a firm toward insolvency. If cash flow becomes insufficient to meet interest and repayment obligations, even a fundamentally sound business can be forced into a financial crisis. The skill lies in finding the right balance, borrowing enough to enjoy leverage, but not so much that a single bad year threatens survival.

Striking the right balance 🔗

Borrowed capital is neither good nor bad on its own. It is a tool. Used by a business with steady earnings and a return higher than its interest cost, it lifts shareholder returns and funds growth that equity alone could not support. Used carelessly by a business with shaky profits, it becomes a fixed burden that erodes returns and invites legal trouble.

The wise approach is to weigh the certainty of the interest obligation against the reliability of the expected returns. A company confident in its profitability can lean into trading on equity. A company facing uncertainty is usually better served by relying more on owned capital. The decision shapes not just the returns to owners, but the long-term stability of the business itself.

What do you think? If you were running a profitable business that needed funds to expand, how much would you be willing to borrow before the fixed interest burden started to feel too risky? And in an uncertain economy, would you choose the higher rewards of thin equity or the safety of thick equity?

References

1. https://cleartax.in/s/debt-instruments
2. https://www.bajajfinserv.in/what-is-debenture
3. https://taxguru.in/company-law/issue-debentures-section-71-companies-act-2013.html
4. https://www.caclubindia.com/articles/issue-of-debentures-under-companies-act-2013-46084.asp
5. https://www.accountingtools.com/articles/what-is-trading-on-equity.html
6. https://www.bajajbroking.in/blog/what-is-trading-on-equity
7. https://www.angelone.in/knowledge-center/trading-account/what-is-trading-on-equity