What is Liquidity Risk?
Liquidity is an asset quality that measures how easy and quick it is to convert an asset or security into cash or equivalent. Liquidity risk is the risk that pertains to the conversion of assets, securities, or bonds into cash without affecting their market price due to unfavorable economic conditions. It is a financial risk and may result in severe cash-crunch for investors in cases of assets like shares and bonds with high liquidity risk. This results in a situation in which businesses and investors may fail to meet their short-term cash requirements or debt obligations.
Table of Contents
- What is Liquidity Risk?
- What are the Reasons for Liquidity Risk?
- What are the types of Liquidity Risk?
- Measures to assess the liquidity of various assets?
- What are the ratios to measure liquidity risk?
- Ways to Manage Liquidity Risk?
What are the Reasons for Liquidity Risk?
Gap between Demand and Supply
In unfavorable economic conditions such as recession, a large gap may arise between the demand for an asset and its supply. Lack of demand forces the asset price to fall. Thus, such market inefficiency may result in liquidity risk. Because the holder of the asset may not be willing to sell the assets at such a low value.
Type of Asset
Marketable securities, bonds, inventory, etc. are more liquid in nature and can be easily converted into cash. Therefore they pose limited liquidity risk. On the other hand, land and building, plant and machinery, etc. are not liquid in nature and may pose significant liquidity risk. Searching for a suitable buyer, with such large amounts, and if the somehow the economy is not in good conditions, creates a big issue in the liquidation of such assets. And it may take a lot of time.
Cash Flow Constraints
Businesses go through phases in which cash flow is constrained or limited but cash outflow is significant. This may create a shortage of cash and liquidity risk.
What are the types of Liquidity Risk?
Funding Liquidity Risk
Funding liquidity risk is the risk of not being able to meet one’s financial obligations due to a lack of liquid funds. The operating cash flows may be low for a company, resulting in the risk of non-fulfillment of its short-term payments. This may result in damage of goodwill, frequent shortages of raw materials and inputs due to supply cuts leading to loss of production, customer shifts, etc.
Market Liquidity Risk
Market liquidity risk means the risk where disposal of the securities in the market is difficult. And disposal in such a situation may entail without incurring a substantial loss in value. This may be due to situations like unstable economic conditions, heavy price fluctuations, etc. Such risk causes the stock prices of a company to fall, leading to a selling frenzy. High supply with no matching demand further leads to a fall in the prices of the stock.
Measures to assess the liquidity of various assets?
There are many measures of liquidity of assets. Some of them are:
Bid-ask spread is the gap between the supply price and what the buyer is willing to pay. Calculation of a ratio between the two prices is done to measure the liquidity of an asset. An asset or security with a smaller ratio is more liquid in nature because it can be easily sold in the market. On the other hand, an asset with a larger ratio means that there is a big gap between the supply price and the price that a buyer is willing to pay for it. Hence, such securities are riskier.
Depth of the Market
Market depth measures how much stock is available for trade and how any order can impact the market price. A deep market is a market where the volume available for trade is high and hence, any big order too will not have an impact on the market price.
A shallow market is an opposite situation where the volume available for trade is limited. Hence, big orders can impact the market price of the security.
Resilience is an asset’s capacity to return to previous price levels after the completion of a big transaction. The calculation of resilience can be done only over a period of time.
What are the ratios to measure liquidity risk?
There are a number of financial ratios that measure liquidity risk in a company.
The calculation of the current ratio is done by dividing the current assets by the company’s current liabilities. This ratio gives an indication of the comfort level of the company in meeting its short-term liabilities, with the available quantum of current assets. Naturally, the higher the ratio, the higher would be the comfort level of the company. And that means the company will have no issue in discharging its current obligations. Similarly, a low ratio or a ratio less than one will mean that the current assets are not adequate enough to meet its current liability requirements.
The quick ratio is another form of the current ratio, but it includes only highly liquid assets in the category of current assets. These assets include cash, marketable securities, and accounts receivables. Therefore, the sum of these highly liquid assets is divided by the total current liabilities of the company to find out the ratio. A higher current ratio indicates that The company is in a good position to meet its current financial obligations and vice-versa.
Interest Coverage Ratio
This ratio measures how capable a company is to pay off the interest on its outstanding loans by its earnings before interest and taxes. The calculation for the Interest coverage ratio is done by dividing the company’s EBIT by its total interest obligations.
A high ratio will mean that the company is in a good position and there is negligible liquidity risk or failure to pay interest on time. On the other hand, a low-interest coverage ratio will imply that the company earns barely enough to meet its interest expenses, and hence, its liquidity position is not very good and interest payment sometimes may delay.
Ways to Manage Liquidity Risk?
Effective Cash Flow Forecasts
Proper estimation and forecasting of cash flow can help a business to effectively plan its liquidity requirements. It can plan its expenses in accordance with the estimated future cash flows and avoid any period of trouble.
Keeping a Track of Liquid Assets
A company or an investor should keep proper track of its liquid assets in hand. This will help it to determine its liquidity position to successfully meet a case of an urgent need. Also, it should know before-hand the proper markets and channels through which it can liquidate its assets quickly in times of emergency.
A business or an investor should keep sufficient investments in liquid assets first. And then go for illiquid assets like land, buildings, etc. This will help it to raise cash in times of urgency without suffering big losses. Also, a well-diversified portfolio is important to be able to handle setbacks if any particular investment fails.
Managing and Reducing Leverage
High debt obligations can cause liquidity risks for a company or individual. Hence, leveraging should be properly managed and controlled. And over-reliance on debt should not be there. Lower leverage means a reduced quantum of liabilities. And it will lead to curtailing the company’s liquidity risk.
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