Everything You Need to Know About Liquidity Risk
Productivity

Everything You Need to Know About Liquidity Risk

By Sphera’s Editorial Team | February 10, 2021

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. 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).

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 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:

  • 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.

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, 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. Lastly, mitigate any 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.

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