What is a primary benefit of using financial leverage?

Using financial leverage primarily increases potential returns on investments because it allows a company to use borrowed funds to invest in projects or assets that can generate returns greater than the cost of that borrowed capital. When a business employs financial leverage, it takes on debt to finance operations or expand its investments, which can magnify the effects of both gains and losses.

When the returns on these investments exceed the cost of the debt—the interest owed on the borrowed funds—the company's overall return on equity is enhanced. This means that the shareholders can experience higher earnings as a result of using less of their own capital while still benefiting from the gains generated by the overall investment. Essentially, financial leverage can lead to higher profitability when businesses perform well, allowing greater returns relative to the equity invested by the shareholders.

This concept serves as a crucial strategy for companies aiming to maximize their return on investment, especially when they are confident in their growth prospects and the expected returns on their investments outweigh the risks associated with the additional debt. Balancing the benefits of leverage with the inherent risks is vital, as leveraging too much can lead to financial distress if returns do not meet expectations.