What indicates a firm's level of financial risk?

The degree of financial leverage a firm employs is a key indicator of its level of financial risk. Financial leverage refers to the use of borrowed funds (debt) to finance the firm's assets. When a firm increases its leverage, it takes on more debt relative to its equity. While this can amplify returns in good economic times, it also increases the potential for losses, making the firm more sensitive to fluctuations in earnings. High leverage can lead to increased fixed obligations due to interest payments, meaning that any downturn in revenue could significantly impact the firm's ability to meet its financial commitments.

In contrast, operational profitability reflects the firm's ability to generate earnings from its operations, which is important but does not directly indicate how much financial risk the firm faces due to its capital structure. The industry average for debt-to-equity ratios might provide some context for evaluating a firm's leverage relative to its peers, but it does not directly measure a specific firm's risk profile. Future growth potential relates to the firm's prospects for expansion and profitability, which is important for investors but does not directly assess the financial risk linked to its current capital structure. Therefore, assessing the degree of financial leverage employed provides a clearer picture of a firm's financial risk.