What is a common consequence of high financial leverage?

High financial leverage refers to the use of borrowed funds to amplify potential returns on investment. One of the most notable consequences of utilizing high financial leverage is the greater potential for earnings volatility. When a company increases its debt, it is taking on fixed obligations in the form of interest payments. This means that during periods of strong performance, the returns on equity can be significantly higher, as the additional income generated exceeds the cost of the debt. Conversely, in times of poor performance or decreased revenue, the same fixed payments can lead to steeper declines in net income, increasing the volatility of earnings.

This amplified effect results from the relatively small equity base being leveraged by a larger amount of debt. Consequently, fluctuations in a company's operating income can lead to disproportionately larger changes in earnings per share. Shareholders may benefit from higher returns during good times, but they are also exposed to greater risks during downturns, making earnings much less stable compared to companies with lower leverage levels.

Understanding this relationship is crucial, as it highlights the risk-reward tradeoff associated with using leverage in finance. High financial leverage can enhance returns when the business is performing well, but it significantly increases the financial risk when performance falters, showcasing the volatile nature of earnings in such scenarios.