As the name suggests, liquidity risk management aims to manage and mitigate the liquid or readily available funds of the organisation. It is a process that monitors the liquidity risk in the present time to meet its short-term obligations without any shortfall or financial loss. Investing in liquidity risk management is a win-win situation for all those who suffered insolvency and bankruptcy during the economic recession of 2008.
What is Liquidity Risk?
Liquidity risk refers to the incapacity of any bank or financial institution to pay off its obligations and dues. Liquidity risk is inherent in every nook and corner of business, posing a threat to their structure of finance and existence.
It can be of two types –
- Funding liquidity risk: It is the inability to obtain an adequate amount of funds at a reasonable cost. For example – Lines of Credit, Bank deposits, Debt borrowing terms
- Asset liquidity risk: It is the inability to liquidate funds from the assets.
For example – Accounts receivable, Marketable securities
The Need to Manage Liquidity Risk
Before the global economic crisis of 2008, financial institutions used to follow liberal liquidity management policies. The exact picture came into notice when banks struggled to maintain adequate liquidity during the crisis, resulting in bankruptcy and failure of top banks of the world. The recession scenario changed the outlook for the better. Banks and central banks understood the need for stringent regulations and the most acceptable ways of managing liquidity risk.
4 Common Sources of Liquidity Risk
Cash flow and liquidity are the two facets crucial for any organisation to maintain its solvency and financial position. Thus, as the business grows, one must keep in mind the following sources of liquidity risk.
- Deficit Cash Flow Management – Cash flow is the lifeline of any business and, thus, tracking its inflow and outflow is crucial. Cash flow management offers a clear idea as to the requirement of cash in the future. A business with unsound cash management struggles to remain profitable and viable in the long run.
- Inadequate Obtaining of Funds – The incapacity of an organisation to acquire an adequate amount of funding at a reasonable cost poses a challenge to the maintenance of liquidity risk.
- Unexpected Capital Expenditures – An untimely capital expenditure like an asset purchase or a major repair creates a hassle in the entire budgeted expenditure of any organisation. This, in turn, causes an increase in operating leverage which in turn heightens the liquidity risk.
- Sudden Economic Crisis – Crises like the recession of 2008 and the Covid scenario of 2020 marks as perfect examples that lead to an increase in liquidity risk owing to massive suffering to the business.
Elements of Liquidity Risk Management
The professional finance team of Pro Bank Austin stated seven crucial elements of liquidity risk management. These are as follows:
- Appropriate corporate governance policies.
- Internal control management.
- A corporate mix of funding sources.
- Reporting and monitoring of liquidity risk management.
- Comprehensive funding plan.
- An appropriate set of strategies and governing structure.
- Maintaining levels of highly liquid marketable securities.
Measuring Liquidity Risk
The key metric of measuring liquidity risk is to identify the reprimands of a liquidity crisis. The following tools are used to measure liquidity risk:
- Examination of Financial Ratios – Analysing and comparing the relationship between two or more financial items gives a better idea of the next course of action to be adopted. These ratios provide a presence indicator to measure liquidity based on its past performance.
The Common financial ratios are:
- Current Ratio – Current ratio refers to the proportion of the current assets to its current liabilities. It measures the ability of the organisation to pay its short-term obligations due within one year. “1” is an ideal current ratio.
- Quick Ratio – This ratio measures the very short-term financial obligations with its most liquid assets. It is also known as the liquid or acid test ratio. A quick ratio of more than 1 is considered appropriate to pay off its current liabilities.
- Cash Flow Forecast – The technique of forecasting the incoming and outgoing cash is significant to measure liquidity. It is prudent for every business to maintain its cash flow and revise the chart frequently. Both short-term and long-term forecasts are important as the short term will enhance the capacity to pay its current liabilities whereas the long term will be used to plan the strategic objectives of the organisation.
- Management of Capital Structure – A blend of capital structure is important for the efficient functioning of an organisation with an adequate amount of liquidity. Maintaining the debt to liquidity ratio acts as a measure of liquidity risk. Leveraging is crucial for liquidity risk management as over-leveraging due to inappropriate debt-equity funds harms the balance sheet position of the organisation.
Common Leveraging measures are:
- Debt-to-Equity Ratio – This proportion of debt over equity ratio measures the long-term stability of an organisation. More debt in the capital structure leads to a high debt-equity ratio implying the loss of debt paying capacity (liquidity risk) of the organisation.
- Return on Equity(ROE) – Return on equity measures the financial performance of the organisation, which is calculated by dividing the net income of the shareholder’s equity. If ROE is greater, it signifies an efficient business, whereas a low ROE denotes poor management of funds.
- Interest Coverage Ratio – It denotes the proportion of earnings before interest and taxes to the amount of interest expense. The interest coverage ratio determines the company can pay off its debt interest expense on time or not to manage its liquidity.
- DuPont Analysis – DuPont analysis is a fundamental technique to measure the financial performance and liquidity risk of a company owing to the breakdown of ROE into three components.
- Operating efficiency
- Asset use efficiency
- Financial leverage
RETURN ON EQUITY(ROE) – Profit Margin x Asset Turnover x Financial Leverage
Mitigate Liquidity Risk-
The easiest way to mitigate liquidity risk is to hold adequate funds to meet future demands.
Significant steps to mitigate or manage liquidity risk are as follows:
- Identify the liquidity risk in advance.
- Develop liquidity risk indicators as metrics to quantify the risk.
- Estimate the cash flows with a gauge of the forecast.
- Make a comparison of the assets and liabilities to judge their illiquidity.
- Conduct a stress test to analyse the worst-case scenario.
- Finally, mitigate the risk using measurable financial performance.
It is only by using a comprehensive solution; we can mitigate the liquidity risk, prosper our business, and can meet its short term obligations.