How is financial leverage defined?

Financial leverage is defined as the use of borrowed funds to increase potential investment returns. This concept revolves around using debt to finance the acquisition of assets, which can potentially enhance the returns on investment compared to using only equity financing. By borrowing money, a company can invest more than it could with equity only and thereby amplify the potential for higher profits.

When leveraged correctly, the returns generated on the additional investment can exceed the cost of borrowing, leading to increased overall profits. For instance, if a firm borrows funds at a lower interest rate than the rate of return on its investments, the difference benefits the equity holders.

Utilizing leverage comes with increased risk, particularly if the investments do not perform as expected, which can lead to greater losses compared to unleveraged scenarios. Hence, understanding how to balance leverage is crucial in financial management.

The other choices do not accurately reflect the concept of financial leverage. Using equity financing to fund operations focuses on ownership financing rather than debt, selling assets to reduce debt pertains to asset management and financial restructuring, and investing in low-risk assets does not directly relate to leveraging but rather indicates a conservative investment strategy.