What is liquidity risk? It is a risk that an entity may not be able to pay its short-term liabilities. This risk can be evaluated in two components.
- Lack of funds: An entity will mainly face difficulties in paying its short-term liabilities if there is a lack of funds and shortage of highly liquid assets that can be easily converted into cash.
- Illiquidity of assets: Suppose that an entity has reasonable amount of assets. However, such assets are not readily convertible into cash or are convertible only at a forced sale price with significant loss. In such cases, the entity will still face difficulties in paying its short-term liabilities.
If liquidity risk is not managed properly, an entity would start defaulting resulting in late payment penalties, fines, and damage to its reputation in the market. Severe liquidity problems would lead to an entity’s downfall and bankruptcy, resulting in the closure of the business.
Liquidity risk management
Liquidity risk management is the process of managing funds and arranging additional funds or liquid assets if required, to meet the short-term obligations. The term liquid refers to an asset’s ability to convert into cash. If an asset is readily convertible into cash such as term deposit receipts etc., such asset will be considered as a highly liquid asset. On the other hand, if an asset such as a piece of land is not easily convertible into cash due to adverse market conditions, such asset will be considered non-liquid asset.
Managing liquidity risk is a challenging task but an important one. Businesses may include the following measures in their liquidity risk management policies:
- The company should not obtain too much credit. It should only obtain credit and borrowings to the extent that it considers safe in terms of repaying it as per agreed terms.
- The company should properly monitor its liabilities and their due dates, and accordingly arrange funds for repayment.
- The company should avoid investing too much money in long term projects if there are some concerns about its liquidity position.
- Ratio analysis can be used to monitor the liquidity position. Current ratio and quick ratio are commonly used to evaluate the liquidity position.