What is trading on equity?

Trading on equity is sometimes referred to as financial leverage or the leverage factor.

Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use 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.