What does 'financial leverage' mean?

Financial leverage refers to the strategy of using borrowed funds to enhance the potential return on an investment. When a business takes on debt, it can invest that money in assets or projects that yield returns exceeding the cost of the debt, thereby amplifying its potential gains. This concept hinges on the idea that with increased risk comes the possibility for increased rewards; if the investments made with borrowed money are successful, the profits gained will be greater than if the business had only used its own equity.

Utilizing financial leverage is a common practice in finance because it allows businesses to maximize their growth potential and returns without needing to raise additional equity, which may dilute existing ownership. However, it is important to manage financial leverage carefully, as it also increases the risk of losses if the investments do not perform as expected.