Liquidity RiskThe risk of being unable to pay short-term obligations without incurring a loss

The primary purpose of starting and running a business is to generate profits.

And as a business continues to operate well, it’s less likely to encounter cash problems.

If operations are smooth, it shouldn’t have a hard time converting its assets into cash.

That is to say, a business that is operating well is more likely to be liquid.

And by liquid, I mean that the business has the ability to pay its obligations without suffering great losses.

Indeed, liquidity is an important element in operating a business.

As much as possible, you would want your business to be able to pay its obligations on time.

Otherwise, your business will be facing issues.

For example, if a business is constantly late in paying its rent, the landlord may choose to not renew the lease contract.

Even worse is if late payments result in penalties, which means unnecessary expenses.

In the worst-case situation, the landlord may choose to evict the business.

So if you’re running a business, you might want to pay attention to its liquidity.

Having said that though, there are just some things that may affect a business’s liquidity beyond its control.

A global crisis may make it harder for a business to operate.

Or a new regulation may make its assets worthless.

These are just among many other factors that can influence a business’s liquidity risk.

In this article, we will be discussing what liquidity risk is about.

What is its definition?

How does it affect a business?

What does a business have to do to address liquidity risk?

We’ll try to answer these questions as go along with the article.

What is Liquidity Risk?

Before we discuss liquidity risk, we must first talk about liquidity.

Simply put, liquidity is a business’s (or individual’s) ability to meet short-term obligations without incurring a loss.

It could also refer to the ability to readily convert a non-cash asset into cash.

For example, if a business is able to convert its inventory into cash within a week or less (without suffering a loss), you can say that it has great liquidity.

Now, from that discussion, we can infer that liquidity risk is the risk of being unable to meet short-term obligations without incurring a loss.

To be more specific, it’s because the business (or individual) is unable to convert assets into cash unless it’s willing to take a loss.

Liquidity risk may also connect to an investment or security’s marketability.

If an investment or security lacks marketability, it’s less likely to be bought or sold in a short amount of time without incurring a loss.

As such, the investment or security carries a high liquidity risk.

We can also relate liquidity risk to the nature and quality of a business’s assets.

If a majority of a business’s assets are non-current assets (e.g. equipment, building, machinery), then it carries a high liquidity risk.

This is because non-current assets will take a long time to convert into cash. In other words, non-current assets have low liquidity.

Conversely, a business that mostly has current assets is more likely to carry a low liquidity risk.

However, this is provided that the business’s assets have good quality.

For example, depending on the quality of inventory, it may be able to sell in a short period or a longer time.

Analysts use liquidity ratios to gauge a business’s liquidity risk. The better the liquidity ratios are, the lower the liquidity risk is.

Factors That Can Affect Liquidity Risk

If a business is experiencing liquidity risk, it will have to sell its assets at a loss just to meet its financial obligations.

Some of the factors that affect liquidity risk are controllable by the business.

However, some of them are beyond their control.

Here are some of the factors that can affect liquidity risk:

Limited Cash Flow – a business will have limited cash if it has more frequent cash outflows than cash inflows. For example, it has to make monthly payments. However, it’s only able to receive every three months. This may result in the business being unable to meet its short-term obligations on time.

Asset Type – Assets may either be current or non-current. Current assets are more likely to be liquid, which means that they’re more readily convertible to cash. Non-current assets on the other will take a longer time to be converted into cash. For example, it’s easier to convert marketable securities into cash than a piece of equipment or machinery.

Inefficient Markets – the value of assets in the open market may be lower than usual. If an asset’s market value is lower than its cost, it will result in a loss if the business decides to sell it in the open market.

General Market Conditions – the demand and supply for an asset can affect its price. If there’s a lack of demand for an asset, it’s less likely to sell. Likewise, if there’s a surplus of supplies, then it’d be harder to sell because of the increased competition. Should there be a lack of buyers and a surplus of sellers at the same time, the liquidity of an asset will be greatly compromised. The business will likely only be able to sell the asset at a loss.

Liquidity Risk Example

Let’s say that you own a trucking business.

This business currently owns three warehouses, one of which is currently unused and has a value of $280,000.

Additionally, it currently owns 12 trucks that cost $115,000 each.

These trucks are fully utilized at the moment.

This means that the business needs them to be fully operational so that it can meet its monthly commitments to its clients.

Unfortunately, on one of its trips, a truck got involved in an accident.

As a result, the truck was totaled making it unable to operate.

You made an insurance claim for the truck, but it will still take months before you’d be able to receive payment.

The issue is that the business still has to meet its commitment to its clients.

And with a truck down, meeting such commitments isn’t feasible.

Not wanting to fail to deliver the business’s commitments, you decide to purchase a new truck for $120,000.

However, your business currently doesn’t have enough cash to make such a purchase.

And the business has exhausted its credit limit.

As such, you resort to selling one of the business’s warehouses.

However, there’s not much demand for warehouses at the moment.

Still, you need cash and you need it ASAP.

Thus, you decide to sell the warehouse at a loss just to be able to have the cash to purchase a new truck.

In this example, your business faced a liquidity risk because it had to sell an asset at loss just to be able to meet its obligations.

Types of Liquidity Risk

There are primarily two types of liquidity risk: Market Liquidity Risk and Funding Liquidity Risk.

Market liquidity risk refers to the risk of being unable to sell assets (e.g. inventory) on a market without incurring a loss. For example, when a new regulation prohibits the sale of a business’s goods, or when the introduction of a new product makes a business’s inventory obsolete, there is market liquidity risk. As you can gather from our example, market liquidity risk is typically caused by external factors. Internal factors can still cause market liquidity risk such as the case when a business constantly produces and sells sub-optimal products. This will ultimately result in the poor reception of the consumer, which will make the products harder to sell.

Funding liquidity risk refers to the risk of being unable to meet financial obligations (especially short-term debts) due to a lack of funding. There are several factors that can cause this. It could be that the management of cash isn’t being handled well. It could also be that it takes a long time for the business to convert its inventory into cash. Either way, funding liquidity risk may result in insolvency if the business is unable to address it properly.