Learn more about liquidity risk in business, its sources and how to measure it. Also be on the safe side with tips on how you can manage the risk in your business.
Before the global financial crisis, most financial institutions did not take liquidity seriously, so they ignored the availability of funds. However, the 2007-2008 financial crisis brought the risk to the radar since most institutions struggled to have adequate liquidity. Due to the crisis, there were massive bank failures, requiring central banks to inject liquidity into the financial systems to keep the economy running. Due to this, government and financial institutions had to reassess the importance of liquidity and the risk that comes with lack of sufficient liquidity.
What is liquidity risk?
3V Finance defines it as the risk that a business will not be in a position to meet its short-term financial commitments like paying salaries, repaying a bank loan, paying service providers and many more. Such challenges can lead to payment defaults by the business or even bankruptcy.
Factors that increase risk
- Revenue generation fluctuations
- Unplanned capital expenditures
- Business disruptions
- An increase in operational costs
- Limited financing facilities
- Poor working capital management
- Poor cash flow management
How to measure the risk
Businesses can use liquidity ratios, like current ratio (a common ratio used to measure such a risk) and quick ratio, to measure the risk. You can calculate current ratio by dividing your current assets by your current liabilities. In this case, current assets are the assets that will be converted into cash within the year, while current liabilities are the liabilities that will be due within the year.
Other ratios used include interest coverage ratio, quick ratio and debt to gross cash flows. Using different ratios will give you a better picture of the risk.
Liquidity risk management
Businesses can mitigate theis risk through several liquidity risk management techniques. Some of there techniques include monitoring and optimising their net working capital, forecasting cash flow and managing the existing credit facilities, as explained below.
Monitoring and optimising net working capital
It is crucial to have an in-depth understanding of how business fluctuations affect financing.
Businesses can improve their working capital through projections and analysis of financial ratios like day sales outstanding (DSO), days payable outstanding (DPO), days inventory outstanding (DIO) and cash conversion cycle (CCC).
Forecasting cash flow
Most businesses may be good at forecasting their profit and loss, but they often neglect forecasting their cash flow because they don’t consider the possibility of illiquidity. However, it is crucial for all businesses to regularly forecast cash flow when making other financial performance projections.
In addition to helping a business avoid liquidity issues when they face unexpected expenses, a robust cash flow forecast can help reconcile the two key financial parameters: profit and cash flow. No matter the profit a business makes, it cannot meet its financial obligations if it cannot turn that profit into cash.
Businesses that do regular cash flow forecasting will also better optimise working capital to meet their long-term financial goals.
Managing existing credit facilities
Businesses mainly use borrowed capita to grow and become more profitable. This borrowed capital enables the businesses to manage short-term and long-term needs such as working capital requirements.
Therefore, a business must build a strong relationship with its lenders by ensuring that it is always in compliance with the agreed terms. A good relationship with the lenders is one way of ensuring that you can get credit whenever you are in need.