You must have heard this term in the world of finance and investment, but do you know what exactly it means? What exactly is liquidity risk, and how does it affect your investments? It is an inherent part of your life, and thus we have tried to cover this aspect of risk in this article comprehensively. By the time you’re done reading this article, you will have a fair idea of why cash is the most liquid asset and liquid company in stock markets? So, let’s get started:
What is Liquidity?
Before understanding the liquidity risk meaning and its ramifications for a financial institution or in personal finance, we should first comprehend liquidity as a term. Liquidity simply means the level of ease of converting an asset into cash. This asset could be anything from gold to equities and from real estate to commercial papers or bonds. An asset is highly liquid or illiquid based on two key parameters: the ease or difficulty involved in its conversion to cash and the profit or loss incurred in this conversion.
This is the premise on which liquidity risk management happens all over the world. For instance: An asset is said to be highly liquid if it can be converted to cash easily without any loss in its value. On the flipside, if there is difficulty in converting an asset into cash and there is a loss in its value, then that asset is termed as illiquid as per the financial jargon.
What is Liquidity Risk?
Now that you understand liquidity as a term, we will now focus on liquidity risk. It is the risk associated due to liquidity of any asset, i.e., the risk involved in selling commercial property as you might think there will be no buyers after 10 years. There is a risk in buying and selling due to multiple reasons, and that risk in the world of finance is known as liquidity risk. This is liquidity risk, in a nutshell.
Let’s understand liquidity risk from different perspectives. For a bank or any company, liquidity risk means their inability to pay off their debts with a minimum of no losses. It could also mean the inability to sell their products and services as there is not much demand for them. For an individual investor, liquidity risk means not being able to sell a stock of any company as there are no buyers for that company.
The reasons for this type of risk can be multi-fold. Now identifying and mitigating this risk is what liquidity risk management is all about. In stock markets, small-cap and mid-cap companies (with a market capitalization below ₹ 5000 crores and 20,000 crores, respectively) usually carry higher liquidity risk as their stocks are not widely traded compared to large-cap stocks like HDFC Bank or HUL. This is because most of those small and mid-cap companies are volatile due to weak fundamentals and irregular cash flows.
Types of Liquidity Risk
There are two broad types of liquidity risk that are explained as follows:
Funding Liquidity Risk: This type of liquidity risk arises from the change in the intrinsic value of a firm.It means that a firm is unable to meet its debt obligations and its short-term liabilities owing to insufficient cash flows generated from the business. This is a red flag for the investors of that firm, and the ramification is a fall in its share price.
There are financial ratios like the current ratio (current assets/current liabilities), quick ratio (cash and cash equivalents/current liabilities), and interest coverage ratio (earnings before interest and tax/total interest income). Liquidity risk management focuses on these key financial ratios to determine the ability of a company to assess the funding liquidity risk.
Market Liquidity Risk: This type of liquidity risk arises out of systematic risk that is difficult to diversify by an investor. Volatility in the equity markets is one of the key reasons behind this type of risk. This volatility leads to illiquidity, due to which investors find it difficult to sell their stock holdings. This is one of the liquidity risk implications. You will have to sell your holdings at a lower price in this scenario, owing to lower demand.
You can measure the market liquidity risk by a parameter known as the bid-ask spread. This spread is the difference between the bid price (buying price at which buyer is ready to take) and the ask price (selling price quoted by the seller). Lower the bid-ask spread, more liquid is the asset class or the market as a whole. On the flip side, the higher the bid-ask spread, the more illiquid asset class or market. Another measure of the market liquidity risk is the volume being traded of a particular stock. These are the measures being tracked in liquidity risk management.
How to manage Liquidity Risk?
Now that you have a good understanding of liquidity risk, its types, and causes. In this section, we will talk about liquidity risk management. Here it starts:
Cash Flow Forecasting: Sales and profit projections are done by most of the companies but what many of them miss is to forecastcash flows. Forecasting the cash flows will give management a better view of where they stand in terms of liquidity.
Optimization of Working Capital:Working capital is a big problem for manufacturing companies that have higher capital expenditure requirements with delayed payments from their customers. There are some ratios to analyse the working capital position in the likes of Day Sales Outstanding (DSO), Days Payable Outstanding (DPO), Cash Conversion Cycle (CCC), etc.
This is all we had for you in this edition of liquidity risk. We hope you better understand what this risk is all about, what its types are, and how to manage it effectively. The bottom line is, whether you are a company or a retail investor, understand the liquidity risk meaning, identify its possibility of occurrence, and take measures to mitigate it.