What does the term "financial leverage" refer to?

The term "financial leverage" refers specifically to the practice of borrowing funds to enhance investment returns. By using borrowed capital, companies can invest more than they could with their own equity alone. This strategy allows businesses to amplify their potential returns on investment; for example, if a company borrows money at a lower interest rate than the rate of return it expects to earn on that investment, leveraging can lead to higher profits.

However, it is crucial to understand that while financial leverage has the potential to increase returns, it also carries risk. If the investments do not perform as expected, the company could face substantial losses, potentially exacerbated by the obligation to repay borrowed funds regardless of investment performance. This balance between risk and reward is a fundamental aspect of financial management and leveraging.

In contrast, using cash reserves to fund operations involves self-financing, which does not involve the external risks associated with debt. Similarly, utilizing equity financing options involves raising capital through selling shares rather than taking on debt, which does not directly align with the concept of leverage as it pertains to borrowing. Reducing debt to improve credit ratings moves in the opposite direction of leveraging, focusing on reducing financial risk rather than increasing potential returns through borrowed capital. Therefore, C is the most accurate depiction