What does the term 'financial leverage' refer to?

Financial leverage refers to the use of borrowed funds to increase the potential return on investment. When a business utilizes financial leverage, it borrows money to invest in its operations or other assets, expecting that the returns generated from these investments will exceed the cost of borrowing. This strategy can amplify profits since the company does not have to use its own equity for the investments and can, therefore, invest a larger amount than it might if only equity capital were used.

By increasing the amount of capital available through borrowing, a business can take larger positions in the market, potentially leading to higher returns on equity if the investments are successful. However, it is important to note that financial leverage also introduces additional risk. If the returns do not exceed the cost of the debt, the business can find itself in a precarious financial position.

In contrast, the other options present more traditional or conservative approaches to financing. For example, using personal savings or equity to fund operations does not involve leverage, as these methods rely on capital that does not incur debt. Similarly, investing in fixed assets without loans suggests a completely equity-financed strategy, which does not utilize the benefits or risks associated with borrowed funds.