Definition: Trading on Equity, also known as financial leverage, is the balance between the cost financing operations with equity or debt and the income earned from the operations. In other words, it’s a gamble. The company is betting that the return from the investment will generate more income than it costs to finance the investment.
Trading on the equity occurs using both equity and debt.
First lets look at an equity example. The board of directors can issue more preferred shares to pay for its expansions or operations. In this case, management is betting that the new expansions will generate more income for the common shareholders than the newly issued preferred shares will require in annual dividend payments.
Companies also finance much of their operations and expansions using debt in the form of bonds or loans. In this case, management is usually convinced that it will be able to generate more profits from the new expanded assets than the interest and principle payments required by the new liabilities.
What Does Trading on Equity Mean?
Depending on the company issuing preferred shares is more profitable than taking on more debt. This is because many investors who think common stock is too risky are interested in the benefits of preferred shares. With equity investors, there are no interest obligations and depending on the class of shares being issued dividends don’t have to be paid annually. This allows the company to gain the capital it needs to expand without immediate cash outlays for interest. It also give the company time to make a profit with the new assets.
As you can see, Trading on Equity is a type of trade off. The firm uses its financing of debt or equity to purchase new assets. In turn, it uses its new assets to pay for or finance its debt and equity obligations.