Liquidity Risk (2024)

What is Liquidity Risk?

LiquidityRisk measures the marketability of an asset and the ease at which is can be converted into cash, without incurring a monetary loss.

Liquidity Risk (1)

Table of Contents

  • What is the Definition of Liquidity Risk?
  • What are Liquid Assets?
  • Liquidity Risk and Premium: Stock Market Investments
  • How to Analyze Balance Sheet Liquidity?
  • Liquidity Risk Calculator
  • 1. Balance Sheet Assumptions
  • 2. Liquidity Risk Calculation Example
  • 3. Liquidity Risk Ratio Analysis

What is the Definition of Liquidity Risk?

The liquidity risk concept can be measured in two forms: 1) market liquidity and 2) financial liquidity.

  • Market Liquidity: Market liquidity describes the time necessary for an asset to be liquidated and sold for cash in the secondary market.
  • Financial Liquidity: The other component of liquidity aside from the timing aspect – financial liquidity – focuses on the price at which the asset was sold relative to its fair value, i.e. the size of the discount required.

The quicker the asset can be converted into cash, the more liquid the asset (and vice versa).

Conceptually, the ease or difficulty the seller encounters while attempting to sell the asset is determined by supply and demand.

  • Seller’s Market → The most favorable scenario, from the perspective of sellers, is if the market demand is high while the supply is low. On that note, liquid assets can be sold at (or near) their fair value, without the seller having to attach a steep discount to incentivize buyers in the market.
  • Buyer’s Market → In contrast, the least favorable condition would be if demand among buyers is low, while supply is over-abundant.

Therefore, a liquid asset should expect to retrieve a higher valuation than if it were an illiquid asset – all else being equal – because of the so-called “liquidity premium” priced into the valuation.

What are Liquid Assets?

In the prior section, we defined the meaning of liquidity, so we’ll provide a list of real-life examples of liquid assets here.

The types of assets deemed the most liquid, aside from cash itself, include the following:

  • Government Bonds (e.g. T-Bills, T-Bonds)
  • Marketable Securities
  • Certificate of Deposit (CD)
  • Savings Accounts
  • Money Market Funds
  • Low-Risk, Short-Term Investments

Because of how quickly these assets can be sold in the market with either no or a marginal reduction in price, the assets listed above are frequently consolidated within the “Cash and Cash Equivalents” line item in the current assets section of the balance sheet.

The next list consists of other assets also considered to be liquid, however to a lesser degree than those above.

  • Accounts Receivable (A/R) →Accounts receivable refers to payments not yet collected but owed to a company by its customers, who paid using credit, instead of cash, for a good or service already delivered (and thus “earned” per accrual accounting). While most customers eventually fulfill such a cash payment obligation, there are often exceptions where the company is later forced to write off the receivables as uncollectible (i.e. bad debt).
  • Inventory →Inventory is another current asset with liquidity that can vary substantially based on the context. Certain inventories have broad applications and can be sold easily at a minor discount, whereas others can be difficult to liquidate even with a significant discount.

Liquidity Risk and Premium: Stock Market Investments

Corporate bonds with high credit ratings and common shares wherein the underlying issuers are financially sound can be relatively easy to sell due to the sheer volume in the bond and public equities market.

Nevertheless, unanticipated circumstances can reduce the demand in the market and the sale price, which could stem from the issuer (e.g. missed earnings guidance) or external events (e.g. economic conditions, geopolitical risk).

That said, the term “liquidity risk” refers to the potential monetary losses incurred by an investor attempting to exit a position due to insufficient buyer demand in the market.

The absence of market demand prevents the investor from selling at the time desired and the sale price might have to be reduced, especially if it is a “fire sale”, i.e. the urgent liquidation of the securities.

Hence, the securities of widely-recognized public companies with high trading volume trade at a premium relative to thinly traded securities from smaller-sized companies with lower trading volume.

How to Analyze Balance Sheet Liquidity?

The balance sheet liquidity ratios are a method to measure the capacity of a company to meet its short-term obligations (<12 months due date).

There are four liquidity ratios widely used and relied upon to determine a company’s near-term financial health.

Liquidity RatioDescription
Current Ratio
  • The current ratio measures near-term liquidity by comparing a company’s current assets relative to its current liabilities.
Quick Ratio
  • The quick ratio, or “acid test ratio”, measures short-term liquidity by comparing the value of a company’s cash and highly-liquid current assets to its current liabilities.
Cash Ratio
  • The cash ratio compares a company’s cash and cash equivalents balance to its current liabilities and short-term debt obligations with upcoming maturity dates.
Net Working Capital Turnover (NWC)
  • The net working capital turnover ratio measures the efficiency at which a company is utilizing its operating working capital base to support its current levels of revenue.

The formula for each liquidity ratio can be found here:

Current Ratio =Current Assets÷ Current Liabilities

Quick Ratio =(Cash and Cash Equivalents+Accounts Receivable)÷Current Liabilities

Cash Ratio =Cash and Cash Equivalents÷Short-Term Liabilities

Net Working Capital Turnover (NWC) =Revenue÷Average Net Working Capital (NWC)

Liquidity Risk Calculator

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

1. Balance Sheet Assumptions

Suppose we’re tasked with performing liquidity analysis on a company with the following balance sheet data.

Selected Balance Sheet Data
($ in millions)Year 1Year 2Year 3Year 4
Cash and Equivalents$20$28$36$44
Marketable Securities10152025
Accounts Receivable20242832
Inventory50515253
Total Current Assets$100$118$136$154
Accounts Payable$65$60$55$50
Accrued Expense40363228
Short-Term Debt80787674
Total Current Liabilities$185$174$163$152

2. Liquidity Risk Calculation Example

Since we’re limited to the balance sheet, we’ll calculate the current ratio, quick ratio, and cash ratio in each period.

Starting with the current ratio, the formula consists of dividing the “Total Current Assets” by the “Total Current Liabilities”.

  • Current Ratio, Year 1 = 0.5x
  • Current Ratio, Year 2 = 0.7x
  • Current Ratio, Year 3 = 0.8x
  • Current Ratio, Year 4 = 1.0x

From Year 1 to Year 4, the current ratio has expanded from 0.5x to 1.0x, which implies the company’s liquidity position is improving over time.

However, the current ratio can be misleading, because the build-up of inventory could potentially artificially “inflate” the liquidity ratio.

Thus, we’ll measure the quick ratio in the next step, where the only adjustment in the formula is that inventory is left out of the calculation.

  • Quick Ratio, Year 1 = 0.3x
  • Quick Ratio, Year 2 = 0.4x
  • Quick Ratio, Year 3 = 0.5x
  • Quick Ratio, Year 4 = 0.7x

3. Liquidity Risk Ratio Analysis

The positive trajectory in the quick ratio confirms that the company is indeed now in better shape from a near-term liquidity risk standpoint.

In the final part of our exercise, we’ll track the company’s cash ratio across the four-year period.

Of the three liquidity ratios, the cash ratio is by far the most conservative, since only the “Cash and Equivalents” line item is used in the formula.

  • Cash Ratio, Year 1 = 0.1x
  • Cash Ratio, Year 2 = 0.2x
  • Cash Ratio, Year 3 = 0.2x
  • Cash Ratio, Year 4 = 0.3x

In closing, we can reasonably derive from our exercise that the company’s financial state – particularly in the context of near-term liquidity – has improved over time, as confirmed by our liquidity ratios.

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Liquidity Risk (6)

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Liquidity Risk (2024)

FAQs

Liquidity Risk? ›

Liquidity risk is the risk to an institution's financial condition or safety and soundness arising from its inability (whether real or perceived) to meet its contractual obligations.

What is an example of a liquidity risk situation? ›

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.

What best describes liquidity risk? ›

Liquidity risk is defined as the risk that the Group has insufficient financial resources to meet its commitments as they fall due, or can only secure them at excessive cost. Liquidity risk is managed through a series of measures, tests and reports that are primarily based on contractual maturity.

What are the causes of liquidity risk? ›

For banks, liquidity risk arises naturally from certain aspects of their day-to-day operations. For example, banks tend to fund long-term loans (like mortgages) with short-term liabilities (like deposits). This maturity mismatch creates liquidity risk if depositors withdraw funds suddenly.

What is the difference between credit risk and liquidity risk? ›

Credit risk is when companies give their customers a line of credit; also, a company's risk of not having enough funds to pay its bills. Liquidity risk refers to how easily a company can convert its assets into cash if it needs funds; it also refers to its daily cash flow.

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.

How do you identify liquidity risk? ›

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.

Why is liquidity risk bad? ›

Market liquidity risk

When market liquidity begins to falter, financial markets experience less reliable pricing, and can tend to overreact. This has a knock-on effect, leading to an increase in market volatility and higher funding costs.

How to avoid liquidity risk? ›

To avoid liquidity risks, business owners or company accountants must keep an up-to-date balance sheet that includes accurate data on their current assets and liabilities. Current assets can include cash, stocks or investments, accounts receivable and in some cases, inventory.

What are the key risk indicators for liquidity risk? ›

KRIs such as the liquidity coverage ratio (LCR), net stable funding ratio (NSFR), and cash flow projections aid in assessing liquidity risk. Banks use these indicators to ensure they can withstand unforeseen liquidity challenges and sustain their operations.

Who is most affected by liquidity risk? ›

The fundamental role of banks typically involves the transfor- mation of liquid deposit liabilities into illiquid assets such as loans; this makes banks inherently vulnerable to liquidity risk. Liquidity-risk management seeks to ensure a bank's ability to continue to perform this fundamental role.

What increases liquidity risk? ›

Strategic Risk

If a credit union implements a new strategy, like new programs to attract shares or increase loan volume, without considering and planning for the impact on cash flows, its liquidity position may be subject to a greater degree of risk.

What are the two reasons liquidity risk arises? ›

Liquidity risk occurs because of situations that develop from economic and financial transactions that are reflected on either the asset side of the balance sheet or the liability side of the balance sheet of an FI.

What is the downside liquidity risk? ›

Downside liquidity risk is measured by higher moment of liquidity-liquidity skewness. Downside liquidity risk premium significantly exists in Chinese stock market. Downside liquidity risk premium is persistent within the future one year.

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).

What is high risk of liquidity? ›

A trading liquidity risk is sometimes also known as a market liquidity risk. This type of liquidity risk is associated with price volatility in the secondary market. In a highly liquid market, prices tend to remain stable due to the high demand for assets. Illiquid markets are prone to price declines.

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.

What is a liquidity event example? ›

Liquidity events allow venture investors to convert their ownership stakes in a startup into cash or liquid securities. Liquidity events can include a startup going public, getting acquired, or a venture investor selling their stake on a secondary market.

What is a real world example of liquidity? ›

Examples of liquid assets may include cash, cash equivalents, money market accounts, marketable securities, short-term bonds, or accounts receivable.

What is the best example of liquidity? ›

Cash is the most liquid asset, followed by cash equivalents, which are things like money market accounts, certificates of deposit (CDs), or time deposits. Marketable securities, such as stocks and bonds listed on exchanges, are often very liquid and can be sold quickly via a broker.

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