What does leverage refer to in financial terms?

Leverage, in financial terms, refers to the use of borrowed funds to increase potential returns on investment. By using leverage, companies aim to enhance their ability to generate profits; this is because they can invest more money than they currently have, increasing both the potential for higher returns and the associated risks.

When a company borrows funds, it is effectively amplifying its purchasing power. If the investments made with this borrowed capital yield a return greater than the cost of borrowing, the company can significantly increase its bottom line. However, it is important to recognize that while leverage can enhance returns, it also increases the risk of financial distress, particularly if the investments underperform or if the company struggles to meet its debt obligations.

The other choices touch on different financial concepts. For instance, using savings to fund projects does not involve borrowing and therefore does not represent leverage. Similarly, the amount of cash a company holds and the ratio of fixed costs to variable costs pertain to cash management and cost analysis, respectively, but neither addresses the principle of using borrowed funds to amplify returns, which is central to the concept of leverage.