What is Liquidity Risk

Liquidity risk is the potential for a financial loss stemming from the inability to meet payment obligations or convert assets into cash when needed, without significant loss in value. It’s the risk that an individual, company, or financial institution can’t quickly and easily turn assets into cash to cover immediate liabilities. 

What is Liquidity Risk in Simple Terms?

• What is Liquidity Risk? Liquidity risk refers to the chance that a company or financial institution may have difficulty accessing funds quickly or at a reasonable cost when it needs to fulfil obligations, such as paying suppliers, repaying loans, or dealing with unexpected expenses. 
• Typically, the definition of liquidity risk can be divided into two main types. Market liquidity risk occurs when assets cannot be sold easily without impacting their value. In contrast, funding liquidity risk happens when a business cannot gather enough cash or secure a loan quickly enough to meet its payments. 
• For example, consider a company that has most of its cash locked in real estate. If it suddenly needs money to pay salaries but can’t sell the property quickly enough, it would be facing liquidity risk. 
• Understanding and managing liquidity risk is essential for banks, businesses, and investors. This helps them avoid financial stress and maintain stability.

Types of Liquidity Risk: Market and Funding

Understanding the types of liquidity risk helps in better financial decision-making.

• Earlier we understood what is liquidity risk, which is the challenge of accessing funds when needed. Now let’s look at its two main types. 
• Market liquidity risk arises when a firm cannot dispose of its assets quickly without a decrease in value, which is often due to limited demand in the market. Funding liquidity risk occurs when the business is unable to raise sufficient cash or credit to meet its obligations. 
• If, for instance, a company has valuable machinery but needs to pay salaries immediately and can’t sell machinery quickly enough, it is at risk for liquidity. 
• Managing liquidity risk is essential to ensure financial stability.

Funding Liquidity Risk (or Cash Flow Liquidity Risk):

• Liquidity risk can be broken down into two main categories. First, there’s funding liquidity risk, which happens when a company struggles to gather enough cash to cover its obligations. 
• Then, we have market liquidity risk, which arises when a company can’t sell its assets quickly without taking a hit on their value. 
• For instance, a firm needing urgent cash might struggle to sell shares during a market crash. Both forms of liquidity risk can impact financial stability.

Market Liquidity Risk (or Asset Liquidity Risk):

• Market liquidity risk, or asset liquidity risk, refers to the challenge of quickly selling an asset without greatly affecting its price. 
• When markets are thin or under stress, even quality assets can be difficult to sell at a fair value. This type of liquidity risk can influence everything from daily operations to long-term investment plans. 
• It is a major concern, especially during volatile or uncertain market conditions.

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What Causes Liquidity Risk?

Liquidity risk often arises from poor internal financial management or from unexpected external shocks. Adequate liquidity risk management should prevent shortfalls and provide stability during troubled times.

• Poor cash flow management: Poor cash flow management occurs when cash inflows and cash outflows are not monitored correctly. 
• Unexpected market events: Unexpected market events, like economic downturns, political instability, or natural disasters, can limit access to funding or lower asset values. 
• Over-relying on a single funding source: Over-relying is risky. If too much dependence is placed on one lender or income stream, a crisis can occur if that source disappears. 
• Holding illiquid assets: It is another issue. Assets that can’t be sold quickly or without a loss can trap capital when cash is urgently needed. 
• Damage to reputation: It can also hurt liquidity. A poor track record or negative publicity can turn away investors and lenders, making liquidity problems worse.

How to Measure Liquidity Risk: Key Ratios and Metrics?

• Understanding what is liquidity risk and the causes of liquidity risk is important for managing it well. You can measure it with key ratios such as the current ratio, quick ratio, and cash ratio. 
• These ratios evaluate a company’s ability to meet short-term obligations. They help spot early signs and causes of liquidity risk, which leads to improved financial planning.

How is Liquidity Risk Measured?

• You can’t predict the future, but you can assess a company’s current liquidity using financial ratios. Tools like the current ratio, quick ratio, and cash ratio indicate how easily a business can meet short-term obligations. 
• Analysing these metrics helps spot early warning signs of liquidity risk and improve financial decision-making.

Key Financial Ratios 

Current Ratio: Current Assets / Current Liabilities

• The current ratio looks at a company’s current assets and current liabilities. It helps determine if the business has enough short-term resources to cover its upcoming financial obligations.

Quick Ratio (Acid-Test Ratio): (Current Assets – Inventory) / Current Liabilities

• The quick ratio, or acid-test ratio, measures how well a company can pay its short-term debts without depending on selling inventory. It provides a clearer picture of immediate liquidity.

Cash Ratio: (Cash + Cash Equivalents) / Current Liabilities

• The cash ratio examines if a company can pay off its short-term debts with only cash or near-cash assets. It is the toughest measure of liquidity and reveals how ready a business is for unexpected financial needs.

Non-Ratio Indicators:

• While financial ratios are helpful, there are also non-ratio signs of liquidity risk. One common example is the bid-ask spread; a wider gap may signal weak market liquidity and make it harder to sell assets quickly at a fair price. 
• Other signs include delayed payments, trouble securing loans, or heavy reliance on short-term borrowing. These indicators help provide a clearer view of a company’s liquidity position.

How to Manage and Mitigate Liquidity Risk?

• Maintain a Healthy Cash Reserve:  Keeping enough cash on hand helps businesses manage unexpected expenses or income drops. It’s a simple yet essential part of managing liquidity risk. 
• Effective Working Capital Management:  Monitoring receivables, payables, and inventory ensures funds move smoothly through the business. This lowers the chances of short-term cash shortages. 
• Diversify Funding Sources: Relying on just one lender is risky. Spreading funding across different sources boosts financial flexibility and improves liquidity risk management. 
• Stress Testing: Running ‘what if’ scenarios helps companies understand how they would handle a crisis. It’s a proactive way to identify weaknesses in liquidity planning.  
• Establish Lines of Credit: Having access to credit facilities provides a financial cushion when needed. It can support operations during tight cash flow periods.   
• Create a Contingency Funding Plan (CFP):  A CFP outlines the steps to take if liquidity suddenly decreases. It helps businesses respond quickly and confidently in challenging situations.  

Real-World Examples of Liquidity Risk

• A well-known example of liquidity risk was the 2008 global financial crisis. During this time, banks struggled to access funds, and many couldn’t meet their obligations. 
• Companies like Lehman Brothers collapsed because they had too many illiquid assets and couldn’t raise cash quickly. 
• More recently, during the COVID-19 pandemic, several businesses faced liquidity challenges due to sudden drops in revenue and limited access to credit. 
• These situations emphasise the need for strong liquidity risk management to handle financial shocks.

The 2008 Financial Crisis: 

• Liquidity risk became clear during the 2008 financial crisis when major banks and firms could not get enough cash to meet their obligations. 
• Lehman Brothers, for example, collapsed because it could not sell assets quickly enough. During the COVID-19 pandemic, many businesses faced similar problems as revenue fell and funding disappeared. 
• These events highlight how important liquidity risk management is for protecting against sudden financial stress.

A Small Business Scenario:

• Imagine a small retail shop that depends on daily sales to pay rent and wages. If sales suddenly drop and the owner has no savings or credit line, they may find it hard to pay bills on time. This situation shows how vulnerable small businesses can be when cash flow is limited.

An Investor’s Predicament:

• Picture an investor who needs to sell shares quickly to cover an emergency expense. If the market is down and buyers are hard to find, they may have to sell at a loss or not sell at all. 
• It’s a difficult situation that highlights how timing and market conditions can impact access to funds.

Studying for the FRM®? Here’s How Liquidity Risk is Tested

• If you’re getting ready for the FRM exam, it’s important to understand liquidity risk. The FRM certification, offered by GARP, emphasises real-world financial risk, and liquidity plays a central role. 
• You’ll need to know how to measure, manage, and reduce liquidity risk using tools like stress testing, ratios, and funding strategies. 
• Questions often connect theory to actual market situations, which helps you apply what you’ve learnt. If you’re asking what is FRM, it’s a globally recognised qualification for professionals who deal with financial risk, with liquidity at its core.

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Conclusion

Understandably, in today’s volatile financial landscape, having awareness of and the ability to manage liquidity risk is paramount. Whatever your role, whether it’s a business owner, investor, or finance professional, making informed decisions relies on knowing how to assess and respond to possible cash shortfalls. Effective liquidity risk management protects against shocks and supports the long-term financial sustainability of your organisation. Organisations that identify early-warning signals and approach uncertainty will make better and more resilient decisions.

FAQs on What is Liquidity Risk

What is the difference between liquidity risk and solvency risk?

Liquidity risk refers to short-term cash flow problems, while solvency risk concerns the long-term ability to pay all debts.

Can a profitable company still face liquidity risk?

Yes, profitable companies can have liquidity issues if their cash is tied up or if they experience delays in cash inflows.

What is an example of a highly liquid asset?

Cash is the most liquid asset, but government bonds and marketable securities are also very liquid.

How do changes in interest rates affect liquidity risk?

Higher interest rates can make borrowing more costly and harder to obtain, which increases liquidity pressure.

Anant Bengani, brings expertise as a Chartered Accountant and a leading figure in finance and accounting education. He’s dedicated to empowering learners with the finest financial knowledge and skills.