What is financial leverage?

Financial leverage refers to the use of borrowed funds, or debt, to enhance investment returns. When a company utilizes financial leverage, it effectively increases its potential returns on equity because it is using debt to acquire additional assets or investments without having to use its own equity capital. This strategy can magnify profits if the investments generate returns greater than the cost of the borrowed funds.

For example, if a company borrows money at a lower interest rate to invest in a project that yields a higher return, the difference between those rates can significantly increase the overall profitability for the equity holders. However, while financial leverage can amplify returns, it also carries the risk of higher losses if the investments do not perform as expected. Thus, the correct answer highlights a crucial aspect of finance that involves balancing potential risks and returns through the strategic use of debt.