How does a higher proportion of fixed costs affect a company's financial risk during economic downturns?

A higher proportion of fixed costs increases a company's financial risk during economic downturns primarily because these costs remain constant regardless of the company's revenue levels. When an economic downturn occurs, companies typically experience a decrease in sales and revenue.

In the case of high fixed costs, expenses related to rent, salaries, and other commitments do not change in response to lower sales. This situation can lead to tighter profit margins or even net losses, as the enterprise still needs to cover the fixed costs despite having fewer sales. As a result, a decrease in revenue directly impacts the company's ability to cover these fixed expenses, heightening financial risk and vulnerability during challenging economic times.

For companies with a higher proportion of variable costs, there is a natural buffer since these costs can decrease in tandem with falling revenues. This characteristic can mitigate financial pressure during downturns, unlike companies heavily burdened with fixed costs, which face more significant challenges in adjusting their expenses to match lower income levels.