What is meant by "financial leverage"?

Financial leverage refers to the practice of using borrowed funds to amplify the potential returns of an investment. By utilizing debt, an investor can control a larger asset base than they could with just their own equity. The idea is that if the returns generated from the investment exceed the cost of the debt (interest payments), the overall return on equity can significantly increase.

For instance, if an investor purchases real estate by taking out a mortgage, the rental income and appreciation become a larger percentage of their total investment due to this leverage. However, it also comes with increased risk, as the investor must meet their obligations regardless of the investment's performance.

Other options do not accurately define financial leverage. The use of cash reserves for investment or personal savings does not involve borrowing and, therefore, doesn't refer to leveraging funds. Similarly, reinvesting dividends focuses more on the growth of an investment through compounding rather than leveraging borrowed money. Thus, the correct definition of financial leverage centers on the strategic use of debt to enhance investment performance.