What does "financial leverage" refer to?

Financial leverage refers to the use of borrowed funds to increase the potential returns on investment. By taking on debt, a company can amplify its investment capacity, allowing it to invest more than it could with equity alone. This can lead to higher returns when the investments performed well, as the profits generated on the invested capital exceed the cost of the borrowed funds. However, it also increases the risk; if the investments do not yield favorable results, the company may struggle to meet its debt obligations.

The concept is central to understanding how businesses can use debt strategically to enhance their growth and profitability. It is important for students of business finance to grasp this balance of risk and reward associated with financial leverage.