What does "financial leverage" refer to?

Financial leverage refers to the practice of using borrowed funds to amplify potential returns on investment. By taking on debt, a company can invest more capital than it possesses in equity, which can lead to higher returns when the investment performs well. The idea is that the profits generated from the investment will exceed the cost of borrowing, thus enhancing the overall return on equity.

Utilizing financial leverage is a common strategy in corporate finance, as it allows companies to pursue larger projects or investments than they could solely with their own resources. This strategy is particularly appealing during periods of low interest rates, where the cost of borrowing is relatively cheap compared to the returns generated from investments.

While other concepts like investing in stocks versus bonds or using cash reserves might relate to financial strategy, they do not capture the essence of financial leverage. Increasing equity could improve a company’s value but does not inherently involve leveraging debt to enhance returns. Therefore, the focus on borrowing to generate higher potential returns distinctly defines the concept of financial leverage.