What is financial leverage?

Financial leverage refers to the practice of using borrowed funds, or debt, in a company's capital structure to amplify potential returns to shareholders. By utilizing leverage, a company can invest more capital into its operations than it could with equity alone. This means that if the investments made with borrowed funds yield returns that exceed the cost of the debt, the excess earnings boost shareholders’ returns.

The primary appeal of financial leverage lies in the potential for higher returns, as long as the company can manage its debt obligations effectively and ensure that the returns on invested capital exceed the interest costs of the borrowed funds. This strategy becomes particularly advantageous during periods of growth when the company can generate significant profits from its investments. However, it’s important to note that financial leverage also increases risk, as high levels of debt can lead to financial distress if the company's revenue does not meet expectations.

This option captures the essence of what financial leverage entails and reflects both the opportunity for increased returns and the associated risks.