Arizona State University (ASU) ACC502 Financial Accounting Practice Exam

Increased financial leverage refers to the use of debt to finance a company's assets. When a company utilizes more debt, it amplifies both potential returns and potential risks associated with the company's financial performance. This is because debt must be repaid, often at fixed interest rates, which creates an obligation that the company must fulfill regardless of its earnings. As a company takes on more debt, the fixed payments can become burdensome, especially if the company faces fluctuating revenues. If the company experiences a downturn or lower sales, the requirement to service this debt can lead to financial distress or even default, significantly increasing the company's overall risk profile. The departure from relying solely on equity financing means that any variations in earnings become more pronounced, which can lead to increased volatility in returns for equity holders. Consequently, while increased leverage can enhance returns during prosperous periods, it proportionately increases the risk during less favorable conditions, making the decision to increase leverage a balance between potential reward and risk exposure.