Define Leverage. What is "Trading on Equity"?

Answer 4A(ii) Leverage Leverage is a financial concept that involves using borrowed capital or debt to increase the potential return on an investment. It is the strategy of using various financial instruments or borrowed capital (like debt) to amplify the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets. Types of Leverage Operating Leverage: This refers to the proportion of fixed costs to variable costs in a company's operations. High operating leverage means that a company has a larger proportion of fixed costs relative to variable costs, which can amplify the effects of changes in sales on operating income. Financial Leverage: This refers to the use of debt to acquire additional assets. Financial leverage is the ratio of a company's debt to its equity. High financial leverage means a company is using a significant amount of debt to finance its assets, which can increase the potential return to equity holders but also increases the risk. Combined Leverage: This is the total leverage effect of both operating and financial leverage. It reflects the overall risk and return situation of the company by considering both the fixed costs in operations and the fixed interest obligations from debt. Trading on Equity Trading on equity, also known as financial leverage, refers to the practice of using borrowed funds (debt) to increase the return on equity. This strategy involves raising debt to finance a portion of a company's operations or investments with the expectation that the income generated will be greater than the cost of debt, thereby increasing the returns to equity shareholders. Key Concepts of Trading on Equity Debt Financing: The company raises capital through borrowing, which could be in the form of loans, bonds, or other financial instruments. Return on Equity (ROE): The income generated from the use of borrowed funds is expected to exceed the interest costs, thereby increasing the returns available to shareholders. Amplification of Profits: When a company earns a higher rate of return on its investment than the interest rate on its debt, the excess returns enhance the overall profitability for equity shareholders.