What does the relationship between financial leverage and risk indicate about Firm B compared to Firm A?

The relationship between financial leverage and risk demonstrates that when a firm uses more debt in its capital structure, it typically increases its risk profile. This is because higher levels of debt elevate the obligations to repay interest and principal, which means that during periods of economic downturn or poor performance, the firm may struggle to meet these obligations. As a result, Firm B, with greater financial leverage, will generally face a higher risk profile compared to Firm A.

The increased leverage amplifies both potential returns and potential losses, resulting in greater variability in the company’s earnings. As such, while financial leverage can enhance returns when the economy is doing well, it also exposes the firm to greater risk of financial distress during downturns.

This dynamic clarifies why Firm B is perceived as having a higher risk profile; the increased reliance on debt financing introduces more potential for volatility and negative consequences, such as default, compared to Firm A, which is assumed to have a lower level of leverage and consequently a more stable financial posture.