What does financial leverage involve?

Financial leverage involves the use of borrowed funds to increase the potential returns on an investment. By utilizing debt, a company can increase its total capital available for investment, which can amplify gains when the investment performs well. The essence of financial leverage lies in its ability to enhance the returns on equity; when a firm invests borrowed capital wisely, it can generate higher profits relative to the equity invested by the shareholders.

This strategy comes with increased risk, as it can magnify losses if the investment does not perform as expected. A company that takes on debt must also ensure it has sufficient cash flow to meet interest and principal payments. The key idea is that the potential for greater returns comes at the cost of increased financial risk.

Other options do not accurately reflect the concept of financial leverage. Using internal funds to finance operations refers to funding through retained earnings rather than borrowing, while eliminating debt focuses on managing liabilities rather than leveraging them for growth. Investing in low-risk assets does not typically involve the strategy of leveraging debt to enhance returns, as such investments are less likely to require high levels of borrowing or create substantial returns.