Definition of Trading on Equity
Trading on equity, which is also referred to as financial leverage, occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on its common stock.
Example of Trading on Equity
To illustrate trading on equity, let’s assume that a corporation uses long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation’s common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity. If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common stockholders will decrease.
There is a limit to the proportion of debt that can be added before the corporation’s financial future is jeopardized.
