What does 'financial leverage' refer to?

Financial leverage refers specifically to the use of borrowed funds to increase the potential return on investment. When a company utilizes financial leverage, it takes on debt with the expectation that the returns generated from the investments made using that debt will exceed the cost of obtaining that debt. Essentially, leveraging amplifies the potential gains (or losses) from an investment because it allows a company to invest more capital than it currently possesses.

For instance, if a firm borrows money at a relatively low interest rate to invest in a profitable project, the returns from the project can significantly enhance the firm's overall earnings. This practice can lead to increased profitability per share for equity holders if the investment succeeds. However, it is also important to be aware that financial leverage comes with risks; if investments do not perform as expected, the company still has the obligation to repay the borrowed funds, which can lead to financial strain.

Other options do not align with the definition of financial leverage. Managing operating expenses relates more to cost efficiency, while using excess cash reserves for investments reflects capital allocation rather than leveraging debt. Analyzing financial statements is an essential part of financial management but does not pertain to the concept of leverage in the context of borrowing funds for investment purposes.