# Trading on Equity — Favourable vs Unfavourable Financial Leverage
Trading on Equity is the practice of financing the business with low-cost fixed-charge funds (debt, preference shares) so that any return earned on those funds in excess of their cost flows to equity shareholders.
## The favourability rule
Compare Return on Investment (ROI) with after-tax cost of debt (or pref. dividend rate):
| Condition | Effect on equity earnings |
|---|---|
| ROI > Cost of Debt | Favourable — borrowing magnifies EPS |
| ROI = Cost of Debt | Neutral |
| ROI < Cost of Debt | Unfavourable — borrowing dilutes EPS |
In many problems you compare ROI vs. pre-tax interest rate; both forms are accepted as long as you are consistent.
## ROI as the benchmark
ROI (a.k.a. ROCE) = EBIT ÷ Capital Employed (Equity + Long-term Debt). If ROI = 18% and the company borrows at 10%, every rupee of debt earns the firm 8% extra that belongs entirely to equity holders.
## Why it shows up as a question
Examiners test whether you can:
1. Compute ROCE.
2. State the cost of debt.
3. Make the comparison and explicitly write "Favourable" / "Unfavourable" with one-line reasoning.
Do not just compute — state the verdict.
## Link with DFL
- DFL > 1 in itself only says "interest exists."
- Whether that leverage helps equity depends on the ROI vs. Kd comparison above.
- A firm can have DFL = 2.5 and still be in an unfavourable position if ROI < Kd.