Correct Answer:
B. High debt in capital structure
Financial risk refers to the risk that a firm will not be able to meet its financial obligations, particularly those related to debt. It is distinct from business risk, which relates to the variability of operating income.
The correct answer is B: High debt in capital structure. When a company relies heavily on debt financing, it incurs significant fixed interest payments that must be made regardless of its operational performance. This increases the likelihood of default if earnings decline or cash flows are insufficient, thereby elevating the firm's financial risk.
Let's look at why the other options are incorrect:
- A: High operating leverage increases a firm's business risk, not financial risk. Operating leverage results from a high proportion of fixed operating costs, making operating income more sensitive to changes in sales volume.
- C: High current ratio (current assets divided by current liabilities) generally indicates strong liquidity. A higher current ratio suggests a firm is better positioned to meet its short-term obligations, thus reducing its short-term financial risk.
- D: High inventory turnover indicates efficient inventory management and strong sales relative to inventory levels. This typically improves cash flow and reduces the risk of obsolescence, which would generally decrease operational inefficiencies and not increase financial risk.