Business Degree Certification Practice Test

In the context of financial risk management, what does "leverage" typically refer to?

1. Reducing debt

2. Using debt to increase potential returns

3. Investing in low-risk assets

4. Increasing cash reserves

The correct answer is: Using debt to increase potential returns

In financial risk management, "leverage" typically refers to the strategy of using borrowed funds to increase the potential return on investment. By utilizing debt, a company or investor can amplify their purchasing power and potentially earn higher returns than they would be able to achieve using only their own capital. This approach can enhance profit margins when investments perform well, as the returns on the total investment (including both equity and borrowed funds) are greater than the cost of the debt. However, it is important to note that while leverage can increase potential returns, it also introduces higher financial risk, as losses can be amplified similarly if investments do not perform as expected. The other options represent different financial strategies or concepts that do not align with the typical understanding of leverage in the context of risk management. For instance, reducing debt and increasing cash reserves involve reducing reliance on borrowed funds, which is opposite to leveraging. Investing in low-risk assets generally implies a more conservative approach that minimizes exposure to risk, contrasting the aggressive nature of leveraging.