Liquidity Risk – Definition, What is Liquidity Risk, and How Liquidity Risk Works?

What Is Liquidity Risk, And How Liquidity Risk Works?
|Updated on: April 5, 2022

A person or business should be able to have enough cash flows and cash available to meet its commitments easily. When a business or person has a liquidity crisis, it does not have enough cash to pay debts. This would lead to selling assets or using cash reserves to pay debts leaving the financial situation more unstable. So, every business or person should follow the right business practices to reduce the liquidity risk and ensure a sufficient cash flow. To understand more about liquidity risk, read on.

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What is liquidity risk?

The ability of a business or a person to pay debts without a loss is called liquidity. Liquidity risk arises when an investment cannot be sold or acquired quickly enough to avoid a loss. It is the risk of the business or person incurring a loss because they are unable to pay off debts on time and at a sustainable cost. The liquidity risk may come into play when the institution is under pressure to pay debts, but the liquidity risk is the perceived ability to do so easily.  It results in very wide bid-ask spreads or large price shifts.

So we can say that liquidity is the ability of a person or business to pay debts and obligations without suffering losses. Managers, credits, and investors use liquidity risk ratio to determine the risk worthiness of the business or person. When a person or business is actually unable to pay off a short-term debt we can say they are experiencing the liquidity risk. This happens when they are not able to convert an asset into liquid cash to make payments without impacting their income or capital.

Analysing liquidity risk

The liquidity risk is indirectly proportional to the size of the security. In normal business circumstances, there is an adequate cash flow for a company or individual to keep up with payments and avoid debt. When there is a difficult market situation or any other stressful circumstance, the company may be unable to make payments. This may necessitate the conversion of an asset into liquid cash. When there is a lack of buyers or a competitive market, the sale of an asset becomes challenging and the asset is not easily converted to cash. This is a liquidity risk situation.

The ratios of risk or uncertainty are used to assess a business for its ability to quickly raise liquid cash. This is achieved  by comparing the short-term liabilities and the liquid assets as described on the financial statements of the company. If there is a huge gap between the amount of available cash and outstanding short-term debt, the business must immediately explore means to generate cash through the sale of assets or other means.

Liquidity risk management is essential  for businesses and financial institutions to lower their liquidity risk and enhance access to cash. The steps that can be taken to manage liquidity risk are:

  • Ensure that the balance sheet shows an adequate balance between liquid cash and outstanding short term debts
  • Plan the balance sheet so that there is a balance between the assets and liabilities so that there is a healthy risk/returns balance
  • Assess the ability of the business to meet its cash flow needs under normal circumstances as well as stressed conditions without harming its overall financial position or incurring a loss
  • Continually evolve and develop strategies to ensure that the business always has access to the necessary collateral and cash to prevent liquidity risk

Liquidity risk in financial institutions

Liquidity risk is of particular importance in financial institutions. Since these institutions work with borrowed funds they need to be able to meet their debt obligations to keep their operations going. When a financial institution is unable to meet its debt obligations, it becomes financially unstable. This is why financial institutions have very strict rules and regulations that measure their stability and liquidity risk. Governments and financial governing bodies, therefore prescribe the kind of assets that a financial institution possesses, how easily they can be liquidated and what their liquidity risk is. A bank or financial institution that faces a liquidity crunch and becomes insolvent creates a financial crisis.

What are the sources of liquidity risk?

We know that a liquidity risk happens when the company is unable to mobilize funds quickly to pay off debts without impacting its capital or profits. To prevent liquidity risk, we have to understand what the sources of the liquidity risk are and why a company may be faced with a liquidity crisis.  There may be many liquidity risk sources that are peculiar to a particular industry or company, but the most common ones are as follows:

  • Poor cash flow management

A company that manages its cash flows well will ensure that it always has enough cash on hand to fulfill its commitments and liabilities. The flow of cash through a business is what keeps it healthy and in the black. A company that neglects to watch and manage its cash flows may inevitably find itself in a position of being unable to make payments. A business with badly managed cash flows will expose itself to higher liquidity risks and also be unattractive to potential investors and shareholders. It may also find it more difficult to obtain financing. Poor cash flow is a sure sign of difficult times to come that may impact the company’s liquidity, operations, profitability as well as overall operations.

  • Lack of financing

If the company has a bad history of not paying debts or fulfilling their loan commitments, they would have more difficulty in securing finance than other companies. This further increases the liquidity risk by constricting the company’s ability to raise liquid funds. A company must manage its capital structure and its debt so that it is attractive to lenders. The ability to raise financing at reasonable rates and favorable terms is essential to lowering the liquidity risk. When a company has a bad credit history, it may be able to raise financing at terms and rates that further destabilize it.

  • Unforeseen disruptions

There is always the unknown factor that no business person could predict. Sudden natural disasters, political turmoil, conflict, and other issues could adversely impact business. The Covid pandemic for example disrupted businesses all over the world. Such an economic disruption can change the entire business climate overnight and create immense pressure that exposes the liquidity risk.

  • Unplanned expenditures

Some businesses are very capital dependent. So, proper management of the financial capital is essential to keep the business healthy. If the business makes a sudden large capital expenditure, it will strain the budget and lock up capital. This highlights and increases the liquidity risk.

  • Profit margin issues

Changes in the market sometimes shrink the profit margins of the business. When the company has falling profit margins, there will be less cash in hand to pay off debts. In such situations, the company would access its cash reserves to keep the operations going which will build up to a liquidity crisis.

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