If a company has a high degree of financial leverage, what does that imply about the firm's risk profile?

A high degree of financial leverage indicates that a company is using a significant amount of debt to finance its operations and growth. This reliance on borrowing can lead to higher potential profits for shareholders because debt can amplify the returns on equity when the company performs well.

When a firm successfully utilizes its leverage to invest in profitable projects, the returns generated on those investments go primarily to shareholders, as the cost of debt (interest payments) remains constant. If the investments yield returns that exceed the cost of the borrowed funds, shareholders benefit from increased earnings per share and overall value of the company.

However, this increased potential for profit also accompanies increased risk. High financial leverage can lead to greater volatility in the company's earnings because debt repayments are required regardless of the company's performance. In times of financial difficulty, the obligation to repay debt can exacerbate losses and create significant challenges for the firm's cash flow and overall financial health.

In summary, a high degree of financial leverage suggests that while there is the potential for higher profits to shareholders, it also entails a greater level of risk that could affect the firm’s stability and financial position.