Everything You Need to Know About Liquidity Risk | Sphera (2024)

You don’t need a financial background to understand why suppliers’ liquidity risk is important. Put simply, liquidity risk involves whether or not companies can they pay their bills. As a manufacturer, it is important to recognize when your suppliers have cash flow problems before it is too late. Here we cover a few questions on the basics.

What is Liquidity Risk?

First, let’s define liquidity. It’s the amount of money businesses readily have available. Liquidity risk is defined as the risk of a company not having the ability to meet short-term financial obligations without incurring major losses.

Liquidity risk does not depend on 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.

When Does Liquidity Risk Arise?

Some liquidity risk includes relying too heavily on short-term sources of funds, or when incoming cash flows suddenly dry up. Liquidity risk that comes without warning is stressful. Liquidity risk also arises when companies have a balance sheet that is too focused on illiquid assets, which cannot be easily converted into cash. The risk that the company’s short-term assets do not cover liabilities is called funding liquidity risk 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. Yetliquidity 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, apopular 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).

How Can Liquidity Risk Cause Insolvency?

Liquidity risk is a short-term situation.Insolvency is the ongoing inability to meet long-term financial obligations. 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.

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. 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. These include:

  1. The current ratio or working capital. This compares current assets, including inventory, and 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. This is more conservative, as it excludes inventory and accounts receivable.

You measure market liquidity risk based on how easily you can exit illiquid assets, like property. This depends on factors such as the asset type, how easily a substitute can be found, 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. 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. .

How Can Liquidity Risk Be Managed?

To manage liquidity risk of your suppliers, and tomitigate the effects of liquidity risk, you want to lower your exposure. First, identify liquidity risk factors. Then develop liquiditykey 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:

  • 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. Thenyou 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.

Why Liquidity Risk Management Is Important

As 2020 showed, 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 threats. So you are not surprised by insolvency, watch for indicators that warn you of any financial risks. Digitization and artificial intelligence-based data systems can help you identify potential liquidity risk among your suppliers, and ensure quality and completeness of data.

Define and use key performance indicators for risk, for example, to track their solvency, or any market changes that might affect prices. Then, assessthe 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. Lastly, mitigateany potential liquidity risk impact through stress tests (simulation and forecasting). Have contingency plans in place for handling negative scenarios.

Digitization and artificial intelligence-based data systems can help you ensure quality and completeness of data. A comprehensive risk management solution can help you figure in the cost of risk and lay the groundwork for dealing with unforeseen events.

*riskmethods was acquired by Sphera in October 2022. This content originally appeared on the riskmethods website and was slightly modified for sphera.com.

Everything You Need to Know About Liquidity Risk | Sphera (2024)


Everything You Need to Know About Liquidity Risk | Sphera? ›

Liquidity risk is defined as the risk of a company not having the ability to meet short-term financial obligations without incurring major losses. Liquidity risk does not depend on net worth.

What do you know regarding liquidity risk? ›

Liquidity risk is the risk of loss resulting from the inability to meet payment obligations in full and on time when they become due. Liquidity risk is inherent to the Bank's business and results from the mismatch in maturities between assets and liabilities.

What are the key risk indicators for liquidity risk? ›

Liquidity Risk Indicators: Low levels of cash reserves, high dependency on short-term funding, or a high ratio of loans to deposits can hint at liquidity risk. Such indicators help banks ensure they can meet their financial obligations as they come due.

How do you study liquidity risk? ›

Liquidity risks are measured by way of the current ratio. It takes all of the entity's current assets and divides them by its current liabilities.

What are liquidity risk concepts? ›

Liquidity risk refers to how a bank's inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM).

What are the three types of liquidity risk? ›

The three main types are central bank liquidity, market liquidity and funding liquidity.

What does liquidity risk affect the most? ›

Another example would be when an asset is illiquid and must be sold at a price below the market price. This liquidity risk usually affects assets that are not traded frequently, such as real estate or bonds.

What are the 2 types of liquidity risks? ›

It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.

Which asset has the highest liquidity risk? ›

Stocks of small and mid-cap companies have high market liquidity risk, as stated above. This is because buyers are uncertain of their potential growth in the future and hence, are unwilling to purchase such securities in fear of incurring losses in the long term.

How do banks solve liquidity problems? ›

First, banks can obtain liquidity through the money market. They can do so either by borrowing additional funds from other market participants, or by reducing their own lending activity. Since both actions raise liquidity, we focus on net lending to the financial sector (loans minus deposits).

Why is liquidity risk important? ›

A sound liquidity risk framework helps to ensure an institution's ability to fulfill its cash and collateral obligations, which are often affected by outside circ*mstances beyond their control.

What is liquidity risk with example? ›

Liquidity risk is the risk that a company or individual does not have the ability to meet its short-term liabilities, as well as its financial payment obligations. This is without incurring a catastrophic loss. It is a metric that doesn't depend on the net worth of the business.

Which tool is used to manage liquidity risk? ›

Liquidity management tools—such as pricing arrangements, notice periods and suspension of redemption rights—can help alleviate the liquidity risk generated by investment funds.

Is liquidity risk systematic? ›

Systemically important financial institutions (SIFIs) contribute to systemic liquidity risks through size and connectedness with other financial institutions, including through excessive reliance on the same providers of liquidity and large common exposures to similar types of assets.

What is the liquidity risk vulnerability? ›

Liquidity risk is the risk that a business will have insufficient funds to meet its financial commitments in a timely manner. The two key elements of liquidity risk are short-term cash flow risk and long-term funding risk.

What is liquidity risk with an example? ›

Market or asset liquidity risk is asset illiquidity. This is the inability to easily exit a position. For example, we may own real estate but, owing to bad market conditions, it can only be sold imminently at a fire sale price.

What is liquidity risk quizlet? ›

What is liquidity risk? • The risk that an institution will not meet its liabilities as they become due as a. result of: - Inability to liquidate assets or obtain funding. - Inability to unwind or offset exposure without significantly lowering market price.

What causes a liquidity risk? ›

What Causes Liquidity Risk? Liquidity risk will tend to occur when a business, organization, or a financial institution is unable to satisfy its short-term loan obligations. This can happen for a number of reasons. For example, it may be that the business or investor isn't able to effectively sell the asset for cash.

What is an example of a liquidity problem? ›

A liquidity crisis occurs when a company can no longer finance its current liabilities from its available cash. For example, it is no longer able to pay its bills on time and therefore defaults on payments. In order to avoid insolvency, it must be able to obtain cash as quickly as possible in such a case.

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