What does the term “financial leverage” refer to?

Financial leverage refers to the use of borrowed funds to increase potential returns on investment. By utilizing debt, an organization can invest more capital than it possesses in equity, which amplifies both the potential gains and potential risks. When an entity takes on debt, it can fund larger projects or investments, thereby increasing the possibility of higher returns if those investments perform well. The strategy is predicated on the idea that the returns generated from the investments will exceed the costs of borrowing, thus leading to greater profitability for the equity holders.

In contrast, investing more equity than debt would indicate a conservative approach, often resulting in lower potential returns relative to the risks involved in leveraging borrowed capital. Avoiding debt completely would eliminate the possibility of financial leverage, as it relies on the use of borrowed funds. Stabilizing revenue streams is more aligned with risk management practices, rather than leveraging financial resources to enhance returns. Thus, the correct understanding of financial leverage is closely tied to borrowing funds to elevate potential investment returns.