The phrase trading on equity is a financial jargon which indicates the utilization of non-equity sources of funds in the capital structure of an enterprise. At a high debt-equity ratio, a firm may not be able to borrow funds at a cheaper rate of interest it may not able to borrow funds at all. This is so because creditors lose confidence in the company which has a high debt-equity ratio. How can creditors have confidence in the company which has only creditors and no equity stockholders? The company will, therefore, have to strive hard to regain a reasonable debt-equity ratio so that the expectations of the market may be satisfied. In fact, equity financing by way of a public sale of stock offers real value of a firm. Traditionally, it has served as a spearhead for expansion of resources and productive capacity involving risk.
Merwin Waterman states that the term trading on equity is seldom heard among the practitioners of business finance. It is, however, a term full of an academic flavor, and textbooks use it in discussions of the financial structures. On the ‘street’, a synonym for this academic phraseology is financial leverage. Financial leverage occurs when a corporation earns a bigger return on fixed cost funds than it pays for the use of such funds. It refers to typical situation in which a firm has fixed charges, securities, such as preferred stock and debentures, and its return on investment must not be equal to fixed charges. When the ROI exceeds interest rate, the financial leverage is favorable, or the firm is said to be trading on equity. It also means that, when there is a favorable financial leverage, the advantage is passed on to equity stockholders. On the other hand, when the ROI is less than the interest rate, the firm loses money by its borrowings. In other words, borrowings place it in an embarrassing position. It is not then worthwhile for it to borrow and have an unfavorable financial leverage.
Thus Trading on equity is defined as the increase in profit /return resulting from borrowing capital at a lower rate and employing it in a business yielding a higher rate. The capital obtained from debt securities is used in a project which produces a rate of return which is higher than its cost. This allows the difference to be distributed to holders of equity securities. In other words, it is possible to lever the return on investment through a tighter management.
When doing business partly on borrowed capital, which, however, includes all forms of business with funds (or properties) obtained on contracts calling for limited payments to those who supply funds, also termed as Trading on equity. The expectation is that these funds will produce a larger revenue than the limited payments call for. Thus, trading on equity may be based upon bonds, non-participating preferred stock, and/or limited rental leases. When a corporation earns more on its borrowed capital than the interest it has to pay on bonds, trading on equity is profitable. But in times of poor business, when the interest on bonds amounts to more than the company makes from the use of these funds, trading on equity is unprofitable. For these reasons, it is said that trading on equity magnifies profits and losses.