How does a company's debt level affect its financial risk?

A company's debt level significantly influences its financial risk, and higher debt levels typically increase that risk. When a business takes on more debt, it becomes obligated to make regular interest payments and, eventually, repay the principal. This obligation can create financial strain, especially if the company faces unexpected challenges or downturns in revenue.

As debt levels rise, so does the risk that the company may not generate enough cash flow to meet its obligations. This can lead to default risk, which raises the cost of borrowing and may impact the company's financial stability. Additionally, higher debt can limit financial flexibility, as funds may need to be directed toward servicing debt rather than being available for investment in growth opportunities or other operational needs.

Conversely, companies with lower debt levels generally face reduced financial risk because they have fewer obligations to meet and greater ability to navigate fluctuations in cash flow. This financial stability allows for greater resource allocation towards strategic growth and investment, contributing to a more resilient overall business structure.