What does 'financial leverage' involve?

Financial leverage involves the use of borrowed funds to amplify the potential return on an investment. By utilizing debt, an investor can increase their investment base without committing as much of their own capital. This strategy can enhance the overall returns on investment when the returns from the investment exceed the cost of the borrowed funds.

In scenarios where the investments perform well, leveraging can result in significant gains relative to the equity invested. However, it's important to note that while financial leverage can increase potential returns, it also heightens risk, as losses can be magnified and may lead to a situation where the cost of the debt outweighs the benefits.

Other options reflect strategies that do not inherently involve borrowing or leveraging capital. Investing in risk-free assets focuses on stability rather than maximizing returns through leveraging. Using personal savings to fund investments does not engage the concept of leverage since it does not involve debt, and reducing liabilities, while a prudent financial practice, does not relate to the principle of leveraging investments for growth. Thus, the correct understanding of financial leverage lies in its use of debt to enhance the capacity for returns.