What does the concept of financial leverage describe?

The concept of financial leverage describes the use of borrowed funds to increase the potential return on investment. Financial leverage allows a company or an individual to invest more than they would be able to with just their own capital, by taking on debt. This strategy can amplify returns because if the investments financed by the borrowed funds perform well, the returns will exceed the cost of the debt, leading to higher profits relative to the equity invested.

Furthermore, financial leverage also magnifies risk; if the investments do not perform as expected, the losses can also be greater than if only equity had been utilized. Therefore, this concept is pivotal in finance, as it highlights the balance between the potential for increased returns and the increased risk associated with using debt.

Other options reflect different financial strategies but do not capture the essence of financial leverage. For instance, using cash reserves pertains to liquidity management rather than leveraging. Managing expenses relates more to operational efficiency and profitability than to capital structure. Issuing stocks is a method of raising equity capital but does not involve the borrowing aspect critical to financial leverage. Thus, the chosen option accurately encapsulates the definition of financial leverage in a financial context.