What does the term "financial leverage" refer to?

The term "financial leverage" refers specifically to the strategy of using borrowed funds to increase the potential return on investment. This concept is based on the idea that by taking on debt, a business can invest more than it could with just its own equity, potentially leading to higher profits. The underlying rationale is that if the return on investments made with borrowed money exceeds the cost of the debt, the owner or shareholders can realize larger profits, enhancing the overall return on their equity.

For instance, if a company borrows funds to invest in a profitable project that yields a higher return than the interest paid on the debt, the additional profit generated can substantially benefit the owners, showcasing how financial leverage can amplify gains. However, it's worth noting that while financial leverage can enhance returns, it also increases risk; if investments do not perform well, the losses can be magnified as the company still has obligations to meet for the borrowed funds.

Understanding this concept is foundational in managing small business finances, as it helps business owners make informed decisions about financing and investment strategies.