What does financial leverage refer to?

Financial leverage specifically refers to the use of debt to increase the potential return on equity for shareholders. By borrowing funds, a company can invest more in its operations than it could using only its own equity. This practice leads to an increase in the variability of shareholder returns because while debt can enhance returns when the company's performance is strong, it can also magnify losses if the company underperforms. Essentially, leveraging debt can create a higher risk-reward scenario for investors, as the fixed interest payments on debt must be paid regardless of how well the company is doing financially.

In contrast, the other options represent different financial concepts. The fixed costs associated with a firm’s operations highlight the costs incurred that do not change with the level of production, but this concept does not directly relate to financial leverage. Similarly, using equity financing exclusively talks about capital structure but overlooks the debt component fundamental to financial leverage. Lastly, the capacity of a firm to generate profit through increased sales relates to operational efficiency and revenue generation, rather than illustrating the effects of debt financing on returns. Thus, option C accurately captures the essence of financial leverage by linking it directly to the increased variability of returns arising from the use of debt.