What does 'financial leverage' involve?

Financial leverage refers to the strategy of using borrowed funds to amplify potential returns on an investment. By leveraging debt, a business or individual aims to increase the amount they can invest, with the expectation that the returns on that investment will exceed the cost of the borrowed funds. This practice is based on the concept that using other people's money can enhance profits, especially when the returns on investments are higher than the interest rate on the debt incurred.

For example, a company that borrows money to invest in growing its operations may achieve higher returns than it would have had it only used its own equity. However, while financial leverage can increase potential returns, it also comes with increased risk. If the investments do not perform as expected, the company still has to service the debt, which could lead to financial distress.

This concept is crucial in financial management as it highlights the balance between risk and reward. Understanding financial leverage allows businesses and investors to make more informed decisions regarding their capital structure and investment strategies.