Liquidity Risk: Definition & Importance

KEY TAKEAWAYS

• Liquidity risk is the risk that a company cannot meet its short-term liabilities and payment obligations. 
• It occurs when an investor, business, or financial institution fails to meet its debt obligations. 
• Liquidity risk often occurs due to an inefficient market or a distinct lack of buyers for a particularly liquid asset. 

What Is Liquidity Risk?

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. Instead, it is based on the liquidity of the company’s current assets and liabilities and the ability to get a fair market price. 

Is Liquidity Risk Important?

Liquidity risk is commonly associated with banks. The liquidity crisis is causing issues for banks all across the world as a result of poor liquidity management. Managing liquidity risks is crucial since every transaction or commitment has an impact on a bank’s liquidity.

One of the most crucial components of an enterprise-wide risk management system is liquidity risk. The liquidity framework of a bank should retain enough liquidity to withstand any type of stress event that may arise.

How Do You Measure Liquidity Risk?

Liquidity risk is calculated by dividing current liabilities by current assets less inventory. The ideal ratio is 1. And anything over it indicates a strong ability to make payments. While anything below it indicates shortcomings.

In terms of a formula, liquidity risk can be shown as follows:

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. This is without losing money and income because there are insufficient people who are willing to purchase the stock. Alternatively, this can occur due to an inefficient market.

Financial institutions rely heavily on borrowed funds; thus it is frequently examined to see if they can repay their debts without suffering significant losses that could be catastrophic. As a result, institutions must adhere to high compliance standards and undergo stress tests to assess their financial soundness.

What Is an Example of Liquidity Risk?

Company X could have a large net worth, meaning it would seem to be in a strong position. But if a lot of that capital is tied up in large, expensive illiquid assets that cannot be easily liquidated and sold off for a fair market price. Then it would still have the potential impact of a higher liquidity risk. 

In terms of the market liquidity risk, you can suffer from liquidity risk if you cannot buy or sell current assets. This is without being adversely affected by the market price of the asset type. For example, the risk of liquidity would be high if a large market trade is done over a short period of time in an insufficiently liquid market. 

A real-life example is the 2008 financial crisis. During this financial crisis, many large central banks and foreign banks failed or faced insolvency issues. This was mainly due to liquidity problems from the central banks. 

Summary

Liquidity risk is one of the many things that business owners need to keep a close eye on. You should always aim to have enough financial stability to pass various stress tests. That involves having adequate liquidity and cash flow to match any outstanding debts that your company has. 

And even if you have enough, there should always be emergency funding sources that you can dip into to meet any unexpected expenses.