Why is it not advisable to finance exclusively with debt?

Financing exclusively with debt can lead to substantial risk for a business, particularly when it comes to financial distress. When a company relies heavily on debt, it must consistently generate enough cash flow to meet its obligations, including interest payments and principal repayments. If the business faces any downturns or unforeseen challenges, high debt levels can lead to a situation where cash flow is insufficient to cover these obligations, potentially resulting in default or bankruptcy.

Moreover, an excessive amount of debt increases the company's costs associated with capital, which is referred to as the weighted average cost of capital (WACC). As debt levels rise, lenders may perceive the firm as a higher risk, which can lead to increased interest rates on new debt. Consequently, this scenario could make it more difficult and expensive for the company to borrow in the future, stifling growth opportunities and reducing financial flexibility.

Thus, the correct reasoning emphasizes that high levels of debt can create financial distress and adversely impact the overall cost of capital, making it imprudent for businesses to rely solely on debt financing. In contrast, a balanced approach that includes equity financing can mitigate these risks and contribute to more sustainable financial health.