"Trading on Equity" is related to:

Question

Accepted Answer

The correct option is 2:
Trading on Equity, also known as financial leverage, is a strategic financial decision to finance a company's assets using a substantial proportion of fixed-cost funds, such as debentures or term loans, in addition to equity capital. The phrase literally means 'using the owners' equity as a base to earn a higher return for the owners by employing cheaper borrowed funds.' This strategy is profitable only when the company's overall rate of return on its total capital employed is higher than the fixed interest rate it must pay on the borrowed funds. Therefore, for a company to be actively 'trading on equity,' its capital structure must involve *More borrowed funds and less share capital* (a high debt-to-equity ratio) to maximise the magnifying effect on Earnings Per Share (EPS). The success of this strategy relies on the management's ability to consistently generate sufficient operating profits to cover the fixed interest cost and leave an even higher residual return for the shareholders.

The incorrect option is 1:
*Less borrowed funds and more share capital* describes a conservative capital structure with low or no financial leverage. In this scenario, the owners' equity is the primary source of finance, and the company has minimal fixed financial obligations. While this structure is financially safer, as the risk of bankruptcy is significantly lower, it does not allow the company to reap the benefits of 'Trading on Equity.' The absence of significant borrowed funds means there is no leveraging mechanism in place to magnify the returns to the ordinary shareholders. This conservative financing mix is the opposite of the one required for a firm to effectively 'trade on equity'.

The incorrect option is 3:
*Only borrowed funds* is an inaccurate and practically impossible description for the capital structure of a joint-stock company. Every company, by legal necessity, must have some initial owners' capital, or equity, to start its operations, which forms the true base of the capital structure. Furthermore, the very concept of "Trading *on Equity*" explicitly implies the existence of equity as the foundation upon which the fixed-cost borrowed funds are leveraged. A capital structure consisting *only* of debt fundamentally contradicts the core meaning and practical application of this financial concept.

The incorrect option is 4:
*Only share Capital* refers to a firm that is completely unleveraged, as it uses zero borrowed funds. The entire principle of 'Trading on Equity' hinges on the use of borrowed funds (debt) to increase the return on the shareholders' equity. Since there is no debt component to introduce financial leverage, a business funded only by share capital cannot be described as engaging in 'Trading on Equity'. This structure eliminates financial risk, but also eliminates the potential for magnified shareholder returns.