What does the term financial leverage refer to?

Financial leverage specifically refers to the use of borrowed funds to increase the potential return on investment. By using debt, companies can invest more than they would be able to using only their own capital. This practice aims to amplify the returns generated from their investments, leveraging the expectation that the returns from the investment will exceed the cost of the borrowed funds.

When a company effectively utilizes financial leverage, it can see significant increases in its earnings per share if the investments perform well. For example, if a company borrows money at a lower interest rate and invests that money in a project yielding higher returns, the surplus can significantly boost profitability.

In contrast, the other options focus on different aspects of finance. The use of equity financing, for instance, involves funding through shareholders without incurring interest obligations. The application of cash reserves relates to internal cash management rather than leveraging debt, and balancing additional income sources does not directly pertain to the concept of leveraging borrowed funds for investment purposes. These distinctions highlight why the essence of financial leverage is deeply tied to borrowing practices and their impact on maximizing investment returns.