Liquidity Risk – Everything You Need to Know

THE RESILIENT ENTERPRISE | THE RISKMETHODS BLOG
Coin-on-rope

You don’t need a financial background to understand why suppliers’ liquidity risk is important. Put simply, can they pay their bills? Only when you recognize that they might be having cash-flow problems can you act before it’s too late. Here we cover a few questions on the basics. Read on.

1. What is liquidity risk?

First, let’s quickly define liquidity. It’s the amount of money businesses readily have available. Think of water in a well. You can easily use it to quench your thirst and water your crops. Liquidity risk is defined as the risk that a company does not have the ability to meet short-term financial obligations without incurring major losses. You have to pump harder and longer to bring up water.

Liquidity risk does not depend on your net worth. One very simple liquidity risk example is when a business has millions of dollars tied up in cutting-edge equipment, but not enough liquid assets to pay their staff or suppliers. The simplest way to lower liquidity risk is to always hold sufficient cash to meet demands. However, this is not optimal when organizations seek to make a profit or expand operations.

2. When does liquidity risk arise?

Some liquidity risk causes include relying too heavily on short-term sources of funds, or when incoming cash flows suddenly dry up. And liquidity risk that comes without warning is stressful. It’s like accidentally tipping over your bucket of water. Liquidity risk also arises when companies have a balance sheet that is too focused on illiquid assets. The risk that the company’s short-term assets do not cover liabilities is called funding liquidity or cash flow liquidity risk.

The other main type of liquidity risk is market liquidity risk, also known as asset liquidity risk. This is the risk of not being able to sell assets such as property quickly or easily because they are highly illiquid. Yet liquidity and illiquidity depend on the market. Do you have potential buyers who urgently want to buy what you have to sell? This increases the liquidity of your asset. In general, price volatility is the cost of liquidity, particularly when referring to liquidity risk for banks and securities trading. This is because there is always a market for liquid assets and securities, but the price is constantly changing.

Speaking of investing and banking, a popular measure of liquidity is the bid-ask spread. This is the difference (spread, or transaction cost) between what a buyer is willing to pay (bid, demand) and the lowest price a seller is willing to accept (ask, supply).

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3. How can liquidity risk cause insolvency?

It helps to remember that liquidity risk is a short-term situation. Insolvency is the ongoing inability to meet long-term financial obligations. The well has run dry. So, reducing liquidity risk is about finding the right balance between investing and having enough cash on hand to cover expenses.

If your supplier is short of cash, they may need to sell illiquid assets quickly. But Illiquid assets such as factories or offices, IT-systems, equipment and machinery can take months or years to sell. And the owner will likely have to sell at a significantly lower price than what the property is worth.

As their customer, you could suffer uncertainty, or lack of supply while your supplier is dealing with a lack of liquidity. But it’s better to act while you can. In our whitepaper, Managing Financial Risk in Your Supply Network, we discuss potential signals of financial distress, and what you can do to protect your business.

4. How do you measure liquidity risk?

The method you use to measure liquidity risk depends on the type. First, we’ll look at funding liquidity risk, which covers what the company owns in liquid assets versus what it owes. So, current assets include cash and assets that can generally be turned into cash within one year. For example, accounts receivable generally provide cash in 10 to 40 days, whereas inventory may take much longer to sell.

Companies can calculate their funding liquidity risk in three basic ways. Each uses a ratio as a measure of liquidity versus financial obligations.

  1. The current ratio, or working capital. This compares current assets, including inventory, to liabilities.
  2. The acid test, or quick ratio. This measures only current assets, such as cash equivalents, against liabilities.
  3. The cash ratio or net working capital is more conservative, as it excludes inventory and accounts receivables.

You measure market liquidity risk based on how easily you can exit illiquid assets, such as property. This depends on factors such as the asset type, how easily a substitute can be found and the time horizon, or how urgently you want to sell.

To measure the liquidity risk in banking, you can use the ratio of loans to deposits. A liquidity risk example in banks is a decline in deposits or rise in withdrawals (which are liabilities for the bank). As a result, the bank is unable to generate enough cash to meet these obligations. This was dramatically illustrated by the global financial crisis of 2008-2009. And if banks are short of cash, customers lose confidence in the bank, and rush to withdraw even more money. Liquidity risk grows.

When measuring liquidity risk, companies and financial institutions also need to consider various scenarios. Recent events have shown that the overall liquidity profile can change quickly. The COVID-19 pandemic translated into a range of business and financial risks. These include credit risk and interest-rate risks, which affect liquidity, as well as long-term financial health.

5. How can liquidity risk be managed?

To manage liquidity risk of your suppliers, and to mitigate the effects of liquidity risk, you want to lower your exposure. First, identify liquidity risk factors. Then develop liquidity key risk indicators, in other words, metrics that allow you to quantify how risky a particular activity is.

When looking at your suppliers’ liquidity, you might investigate their credit rating or profit margin, for example. Here are a few other ideas:

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  • Estimate Cash Flow
    With a cash flow forecast, you gauge the amount of cash that a supplier will have available short-term. To support supplier liquidity, you can pre-pay invoices, for instance. In this way, they can meet their financial obligations while producing the parts you need.
  • Compare Assets and Liabilities
    Has your supplier invested heavily in equipment recently? By comparing assets and liabilities, your supplier can evaluate how much revenue is available as cash, and what is tied up in illiquid assets.
  • Conduct Stress Tests
    Work through worst-case scenarios with your supplier. Stress testing reveals liquidity risk drivers and risk areas to watch out for. You become better prepared for an economic shock. Using this information, you and your suppliers can develop safeguards to mitigate these risks.

In short, to ensure that liquidity risk management programs are effective, you and your suppliers need to agree on which liquidity risk factors to watch. Then you need real-time monitoring, accurate, and consistent data, along with ready-made plans and processes, so you can respond quickly should liquidity risk scenarios arise.

6. Why liquidity risk management is important

As 2020 showed, in an economic shock, formerly profitable businesses can be suddenly strapped for cash. To protect your business from financial impacts arising from supplier liquidity risk, you need to identify, assess and mitigate the threats. Watch for indicators that warn you of any financial risks, so you are not surprised by an insolvency. Digitization and artificial-intelligence-based data systems ensure quality and completeness of data.

  • Identify potential liquidity risks among your suppliers. Define and use key performance indicators for risk, for example, to track their solvency, or any market changes that might affect prices.
  • Assess the impact of product shortfalls or supplier financial distress on the category and on production. Then monitor liquidity risks in real-time to be able to recognize negative patterns quickly.
  • Mitigate any potential liquidity risk impact through stress tests (simulation and forecasting). Have contingency plans in place for handling negative scenarios.

Use a comprehensive risk management solution that figures in the cost of risk. Lay the groundwork for dealing with unforeseen events. Then your suppliers, and you, can keep the cash flowing and continue to draw from the well.

Supplier liquidity risk could signal financial distress. Learn about Managing Financial Risk in Your Supply Network.

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