Trading on equity occurs when a company incurs new debt (such as from bonds, loans, or preferred stock) to acquire assets on which it can earn a return greater than the interest cost of the debt. If a company generates a profit through this financing technique, its shareholders earn a greater return on their investments. In this case, trading on equity is successful. If the company earns less from the acquired assets than the cost of the debt, its shareholders earn a reduced return because of this activity. Many companies use trading on equity rather than acquiring more equity capital, in an attempt to improve their earnings per share.
Trading on equity has two primary advantages:
- Enhanced earnings. It may allow an entity to earn a disproportionate amount on its assets.
- Favorable tax treatment. In many tax jurisdictions, interest expense is tax deductible, which reduces its net cost to the borrower.
However, trading on equity also presents the possibility of disproportionate losses, since the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. The concept is especially dangerous in situations where a company relies upon short-term borrowings to fund its operations, since a sudden spike in short-term interest rates may cause its interest expense to overwhelm earnings, resulting in immediate losses. This risk can be mitigated through the use of interest rate swaps, where a company swaps its variable interest payments for the fixed interest payments of another entity.
Thus, trading on equity can earn outsized returns for shareholders, but also presents the risk of outright bankruptcy if cash flows fall below expectations. In short, earnings are likely to become more variable when a trading on equity strategy is pursued.
Because of the increased variability in earnings, a side effect of trading on equity is that the recognized cost of stock options increases. The reason is that option holders are more likely to cash in their options when earnings spike, and since trading on equity leads to more variable earnings, the options are more likely to earn a higher return for their holders.
The trading on equity concept is more likely to be employed by professional managers who do not own a business, since the managers are interested in increasing the value of their stock options with this aggressive financing technique. A family-run business is more interested in long-term financial stability, and so is more likely to avoid the concept.
Example of Trading on Equity
Able Company uses $1,000,000 of its own cash to buy a factory, which generates $150,000 of annual profits. The company is not using financial leverage at all, since it incurred no debt to buy the factory.
Baker Company uses $100,000 of its own cash and a loan of $900,000 to buy a similar factory, which also generates a $150,000 annual profit. Baker is using financial leverage to generate a profit of $150,000 on a cash investment of $100,000, which is a 150% return on its investment.
Baker's new factory has a bad year, and generates a loss of $300,000, which is triple the amount of its original investment.
Trading on equity is also known as financial leverage, investment leverage, and operating leverage.