What does financial leverage refer to?

Financial leverage refers to the strategy of using borrowed funds to invest in assets, with the objective of increasing the potential returns on equity. This concept is based on the premise that by taking on debt, a company can amplify its operational capacity and enhance its profits, assuming that the returns generated from the investments exceed the cost of borrowing.

When a company employs financial leverage, it can access greater amounts of capital than it might be able to using only its own funds. This borrowing allows the company to invest in projects or assets that can yield higher returns, thereby potentially increasing the value of the equity held by shareholders. The increased risk associated with financial leverage comes from the obligation to repay the borrowed funds, which can result in higher losses if the investments do not perform as expected.

Utilizing one's own funds exclusively pertains to equity financing, which does not constitute leverage. Investing in low-risk securities generally involves less risk and lower potential returns, which does not align with the concept of leverage, as leverage seeks to increase returns through higher risk. Finally, investing in equity markets exclusively does not encapsulate the essence of financial leverage, as it is concerned with the use of external debt rather than the category of the investment itself.