What is liquidity risk?
Liquidity risk in economics is the capability of a company to meet its short-term debts, based on its current liquid assets.
Liquidity is the capability of an asset to be transformed immediately into cash without producing a loss in its value. Current assets are liquid assets that can be converted into cash within 12 months, such as cash on hand and in banks, customer debts, short-term financial investments.
A couple of examples to understand the concept
An example of liquidity risk would be when a company has assets in excess of its debts but cannot easily convert those assets to cash and cannot pay its debts because it does not have sufficient current assets.
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. If we were to urgently sell an illiquid asset, we would lose profits by having to lower its price in order to sell it.
How do we measure liquidity risk?
- Indicates a company’s ability to meet upcoming debt payments with the most liquid part of its assets (cash on hand and short-term investments).
- It is the ratio between current assets (liquid resources of the company) and current liabilities (short-term debts).
- An optimal liquidity ratio is between 1.5 and 2.
- This formula does not take into account inventories because of their low capacity to be converted into cash in the short term.
- It is calculated by dividing current assets less inventory by current liabilities.
- The optimum ratio is 1, above this figure there is good capacity to meet payments, below 1 there are weaknesses.
- It is obtained by dividing cash on hand plus financial assets (cash and cash equivalents) by current liabilities.
- The optimum ratio is 1.
How can we manage liquidity risk?
The liquidity policy should be designed according to the specific characteristics of each company, establishing a contingency plan for possible crises.
Broadly speaking, we could highlight the following practices to reduce liquidity risk:
- Maintain sufficient cash on hand.
- Be able to access loans and diversify funding sources.
- Ability to convert liquid assets into cash quickly.