What impact does financial leverage have on business risk?

Financial leverage increases business risk as it amplifies potential losses, but can also enhance potential profits.

Financial leverage, also known as trading on equity, refers to the use of borrowed funds to finance the purchase of a company's assets. It is a double-edged sword that can significantly impact a business's risk profile. On one hand, if a company's investments funded by debt generate a higher rate of return than the interest on the borrowed funds, the company can achieve higher earnings, thereby enhancing potential profits. This is the upside of financial leverage.

On the other hand, if the return on investments is less than the interest on the borrowed funds, the company will incur losses. This is because the company still has to pay interest on the borrowed funds, regardless of whether it makes a profit or a loss. This amplifies potential losses, thereby increasing business risk. This is the downside of financial leverage.

Moreover, high financial leverage can lead to financial distress and bankruptcy if a company is unable to meet its debt obligations, especially during periods of economic downturn or business downturn. This is because the company's fixed costs, such as interest payments, increase with higher financial leverage, making the company more vulnerable to cash flow problems.

In addition, financial leverage can also increase the volatility of a company's earnings, as it magnifies the impact of changes in sales on the company's net income. This can lead to greater uncertainty and risk for the company's shareholders.

Therefore, while financial leverage can enhance a company's potential profits, it also increases its business risk. It is crucial for a company to carefully manage its financial leverage to balance the potential benefits and risks.