Trading on equity is an older name for financial leverage, the use of borrowed money or preferred stock, rather than only common shareholders' funds, to finance a company's assets. If the assets earn more than the cost of the borrowing, the surplus goes to the shareholders and their return rises. The main entry covers how leverage is measured.
Why it was called trading on equity
The phrase reflects how lenders view a company. A business can borrow because its owners' equity acts as a cushion that protects creditors, so the company is in effect "trading" on that equity to raise extra funds. The more equity it has, the more it can usually borrow. The term appears mainly in older corporate finance texts and in some Commonwealth exam syllabuses; modern usage prefers financial leverage or simply leverage.
Trading on equity works in both directions. Suppose a company earns a 12 percent return on assets and borrows at 7 percent. Each borrowed dollar adds about 5 cents of profit for shareholders, before tax, lifting return on equity (ROE). If the return on assets falls below 7 percent, the fixed interest expense still has to be paid, and shareholders' returns fall faster than they would without debt.
Common measures of how far a company is trading on equity include the debt-to-equity ratio, the debt ratio and the equity multiplier.