What is Liquidity Risk?
‘Liquidity Risk’ means ‘Cash Crunch’ for a temporary or short-term period, and such situations generally harm any business and profit-making organization. Unable to meet short-term debt or short-term liabilities, the business house ends up with negative working capitalNegative Working CapitalNegative Working Capital refers to a scenario when a company has more current liabilities than current assets. It implies that the available short-term assets are not enough to pay off the short-term debts. in most cases. It is a familiar cyclical situation during a recession or when a particular economy is not doing well.
On the other hand, the company must pay its short-term expenses, payments to its Creditors, short-term loans, etc., every month as a part of its liquidity risk management. However, when they face a shortage of cash or default of huge payments from their clients, they look to liquidate or sell some of their assets to infuse cash flow into the system.
Table of contents
- Liquidity risk refers to an organization facing a shortage of funds to meet its short-term obligations. Such a situation can pose a significant threat to the financial stability and profitability of the organization.
- One common method for measuring liquidity risk is the current ratio, which is the value of current assets divided by current liabilities.
- Examples of liquidity risk include the inability to pay off short-term debts due to significant losses or damages during operations and failure to secure appropriate funding within a specific time frame.
Liquidity Risk Explained
Liquidity risk refers to financial uncertainty for a specific time frame for a commodity, financial asset, or security because it cannot be traded immediately in the market as buyers are not interested or the economy is going through a cyclical shift that shows a depleted demand for the asset in question.
For an organization looking to pay its creditors on time, and manage a healthy cash flow, it should be one of the main objectives of the finance team to ensure they conduct their market liquidity risk analysis from time to time.
In simpler terms, it is important to have resources parked in areas that are easy to liquidate to meet immediate financial requirements. An organization with a very low liquidity risk is said to have close to no risk of facing insolvency.
This concept stands true in investment in the stock market as well as in the business world. The inability to sell a particular stock in the stock market for a fair price in a particular time frame is often referred to as trading liquidity risk.
On the other hand, if a business is unable to repay its creditors on time despite trying to sell a few assets to meet the requirements, it is referred to as funding liquidity risk. We will learn about both these types in detail through this article.
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Liquidity Risk Explained in Video
Let us understand the concept of liquidity risk management with a few practical and relatable examples from daily life. These will help us understand the all-pervasive nature of the concept in business and investment.
- Inability to meet short-term debt due to exceptional losses or damages during Operations.
- Unable to meet proper funding within a specific time frame. In most Startup funding-based Companies, there is a risk of break-even. Thus, if the Business does not get the next funding, there can be a possibility of Liquidity risk.
- The rise of material causes rises in manufacturing expenses for the concern. For example, liquidity risk can rise in commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units. prices are not welcome for the business, manufacturing Auto Ancillaries.
For example, if we analyze the financial ratiosAnalyze The Financial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on. of Suprajit Engineering Ltd., we would find the followings:
- Revenue grew at 12.17% in FY18 v/s FY17
- Material costing has bumped up by 16.06%
- Gross Profit at 45.74% v/s 47.56% a year ago.
Because of the rise in the price of Iron & Steel, Aluminum, Zinc will lower the initial marginInitial MarginInitial margin refers to the equity to be contributed by the investor trading on margin to the margin account, and it is expressed as a percentage of the total purchase price. of the business due to higher raw material costs.
One of the prime measurements of market liquidity risk is the application of the Current RatioApplication Of The Current RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities . The current ratio is the value of current or Short-term liabilities as per Current Liabilities. The Ideal ratio is believed to be more than 1, which suggests the firm can pay its current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. from its short-term assets.
Sears Holdings stock fell by 9.8% due to continuing losses and poor quarterly results. Sears’ balance doesn’t look too good either. Moneymorning has named Sears Holding one of the five companies that may go bankrupt soon.
Let us take another example of the liquidity risk of Ruchira Papers Ltd an Indian Company.
The following are the current assetCurrent AssetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. and Current liability standings of Ruchira Papers Ltd for the year ended FY17 and FY18. Thus we can derive the following from the given data.
- Revenue grew by 6.14% on a Yoy basis, Profit Before taxProfit Before TaxProfit before tax (PBT) is a line item in a company's income statement that measures profits earned after accounting for operating expenses like COGS, SG&A, depreciation & amortization, and non-operating expenses. It gives the overall profitability and performance of the company before making payments in corporate taxes. increased by 25.39%, with a PBT margin of 12.83% in FY18 vs. 10.84% in FY17.
- The net profit margin stood at 8.36% in FY18 vs. 7.6% in FY17, and Net profit grew by 17%.
- The current Ratio during FY 18 stands at 1.31 v/s 1.4 in FY 17, which can be termed as mild slippage in Operational efficiency and a decrease in Working CapitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)". But still, 1.31 of the Current ratio is very healthy compared to the Ideal one of 1.
- Inventory has increased by 23%, which is less than the sales growth of 6%, Accounts ReceivableAccounts ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. increased by 8.67%, which is also more than Revenue growth. Most of the Inventory is funded by short-term borrowing and Cash, which resulted in a decrease in cash by 23% and a rise in Short-term borrowings by 30.13%.
These are some classic Liquidity risk examples. Despite higher revenue and higher profitability, the company’s current ratio has slipped marginally. In contrast, the excess inventory and rising Accounts Receivable put pressure on the working capital, which resulted in a decrease in Cash and equivalentCash And EquivalentCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. and an increase in short-term borrowings. The future operation has to be done carefully so AR-to Sales should be less than the previous year’s AR to Sales ratio, and then there should be an increase in cash and a decrease in Short-term borrowings.
As per one Ace Investor, Mr. Warren Buffet, ‘I’ve seen more people fail because of liquor and leverage.’ Thus, Mr. Buffet emphasizes the term ‘leverage’, ‘Borrowings’ or; ‘Debt.’
As an example of liquidity risk, the Short term and long-term borrowings of Bhushan Steel Ltd. are as follows:
|B/S data of Bhushan Steel Ltd||FY14 (INR Cr.)||FY13 (INR Cr.)|
|Share holder’s funds||9,161.58||9,226.34|
Due to poor operational efficiency, the business is being funded by Short-term borrowings, which have increased by 20%, and long-term borrowing has increased by 18%, respectively. Due to a jump in short-term loans and lower returns from business, the borrowings got a pileup, and the total borrowings have increased by 18%, whereas the Shareholder’s wealth got slashed by 1%. D/E ratioD/E RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. , which should ideally be less than 1, has increased to 3.45 in FY14 v/s 2.91 in FY13.
How is it Controlled?
There are several instances when unexpected losses or the liquidity crunch could be overcome with smart liquidity risk management involvements, which are listed as follows:
- A short-term loan or bank overdraftBank OverdraftOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer. can be taken; the amount should be restricted to the future possible earnings that the company will receive in the coming days. For liquidity risk management, a Sundry Debtor will pay the bill in the coming 15 days, and hence the short-term cash crunch can be met by taking a bank overdraft of Bills of exchange.
- If a big order bookOrder BookAn order book electronically records all open (buy and sell) orders for a specific stock, bond, derivative, currency pair, futures, or Cryptocurrency. It also lists the order history by price and volume. Thus, it helps traders and analysts understand market trends, popular securities and make informed investment and trading decisions. has been canceled, no amount has been received against the bill, and the manufacturing process starts (from raw materials purchase to hire of labor). The liquidity risk management should not hinder the work process. Rather the liquidity risk management should communicate to the marketing team to sell the excess production at a nominal rate to incur the cost of production.
- Starting from Developed EconomyDeveloped EconomyA developed economy is the one that has a high per capita income or per capita GDP, a high degree of industrialization, developed infrastructure, technical advances, and a relatively high rank in human development, health, and education. to a Developing Economy, all the countries face excess liquidity in the system due to a rise in the bond rate, a rise in the cost of laborCost Of LaborCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes., cost of production, and cost of Raw-materials. The rising cost inched up at every aspect of manufacturing. The Oil-importing nation feels the heat of inflation when the international crude-oil price rises.
Frequently Asked Questions (FAQs)
Market liquidity risk arises when an organization holds assets that cannot be easily sold or converted into cash due to a lack of buyers or sellers in the market. Market liquidity risk can result from various factors, including changes in market conditions, unexpected shocks to the economy or financial system, or changes in investor sentiment.
Funding liquidity risk is a specific type of liquidity risk that arises when an organization cannot obtain the necessary funding to meet its financial obligations. For example, this can happen when an organization’s lenders or investors withdraw their support or when borrowing costs rise significantly.
The liquidity risk premium is the additional return investors require in exchange for investing in assets with higher liquidity risk. This premium compensates investors for the potential for loss that can arise from holding assets that may not be easily sold in a crisis. The liquidity risk premium can be considered a type of insurance premium that investors pay to protect themselves against a liquidity crisis.
This has been a guide to what is Liquidity Risk. Here we explain its examples, measurement, and how to control Liquidity Risk. You may also have a look at these articles below to learn more about Corporate Finance –