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.
- The current ratio, or working capital. This compares current assets, including inventory, to liabilities.
- The acid test, or quick ratio. This measures only current assets, such as cash equivalents, against liabilities.
- 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.