What does 'financial leverage' mean?

Financial leverage refers to the strategy of using borrowed funds to amplify potential returns on an investment. When an organization or an individual takes on debt, they can invest a larger amount of capital than they would be able to with just their own funds. This practice can significantly increase the potential gains if the investment performs well, as the returns are based on the total investment made, including both borrowed funds and equity.

For example, if a company takes out a loan to purchase additional assets or expand its operations, the returns generated from these investments can exceed the interest expenses associated with the borrowed capital. However, it's important to note that while financial leverage can enhance returns, it also increases the financial risk associated with the investment, as losses can also be amplified.

The other options fail to capture the essence of financial leverage. Using cash reserves pertains to self-funding operations and does not involve debt. Investing in stocks only does not imply leveraging borrowed funds, as it can be done with cash alone. Finally, reducing operational costs relates to enhancing efficiency rather than leveraging borrowed funds to increase potential returns.