What does the term 'financial leverage' refer to?

What does the term 'financial leverage' refer to?

• A. The total amount of capital a company has
• B. The use of borrowed capital to increase investment returns
• C. The ratio of debt to equity in a company's capital structure
• D. The ability to generate profits from sales

Answer: (B)

The term 'financial leverage' specifically refers to the use of borrowed capital to amplify potential investment returns. It involves taking on debt in order to increase the amount of money invested; this can lead to higher returns if the investment performs well. Essentially, financial leverage allows a company to use fixed capital with a relatively small initial investment to generate greater profits. When a company uses financial leverage, it increases its potential return on equity because it can invest more money than it would be able to using only its own resources. For example, if a company borrows funds at a lower interest rate than the returns generated from the investments made with those funds, the excess return contributes to increased profitability for shareholders. The key aspect of financial leverage is the increased risk associated with it as well; while it can help in magnifying returns, it can also lead to greater losses if the investments do not perform as expected. Understanding how leverage works is crucial for making informed financial decisions.

The term 'financial leverage' specifically refers to the use of borrowed capital to amplify potential investment returns. It involves taking on debt in order to increase the amount of money invested; this can lead to higher returns if the investment performs well. Essentially, financial leverage allows a company to use fixed capital with a relatively small initial investment to generate greater profits.

When a company uses financial leverage, it increases its potential return on equity because it can invest more money than it would be able to using only its own resources. For example, if a company borrows funds at a lower interest rate than the returns generated from the investments made with those funds, the excess return contributes to increased profitability for shareholders.

The key aspect of financial leverage is the increased risk associated with it as well; while it can help in magnifying returns, it can also lead to greater losses if the investments do not perform as expected. Understanding how leverage works is crucial for making informed financial decisions.