What are the consequences of a high financial leverage?

High financial leverage can lead to increased profits but also heightens the risk of significant losses.

Financial leverage, also known as gearing, refers to the use of borrowed money to finance a company's operations and investments. When a company has high financial leverage, it means that a large portion of its capital comes from debt. This can have both positive and negative consequences.

On the positive side, high financial leverage can significantly increase a company's potential profits. This is because the company is using borrowed money to finance its operations, which means it can invest in more projects and generate more income than it could with its own capital alone. If these investments are successful, the company can earn a higher return on equity, which benefits shareholders.

However, high financial leverage also comes with increased risk. If the company's investments do not generate enough income to cover the cost of its debt, the company could end up losing money. This risk is particularly high in volatile markets, where the company's income can fluctuate significantly. In the worst-case scenario, if the company cannot meet its debt obligations, it could end up in financial distress or even bankruptcy.

Moreover, high financial leverage can also make a company more vulnerable to interest rate increases. If interest rates rise, the cost of the company's debt will increase, which could further strain its finances. This is particularly a concern for companies with variable-rate debt, where the interest rate can change over time.

In summary, while high financial leverage can boost a company's profits, it also increases its financial risk. Therefore, companies need to carefully manage their level of financial leverage to balance these potential rewards and risks.