What is liquidity risk exposure?

Liquidity risk is the fluid form of short-term financial risk. Liquidity is the state of the short-term cash flow position of an entity. It indicates the entity's ability to pay its debts and expenses in the short term without incurring any capital transaction in assets for the funds' arrangement. The liquidity risk is the inability to sell the marketable securities or realize the liquid assets or funds blocked by the financial institutions. It also gives way to the credit risk. An extreme adverse situation may run the risk of insolvency at times.

Sources of liquidity risk

Liquidity risk management is the prime need of any entity or individual to maintain the continuity of operations. Therefore, it is important to know about the possible sources of liquidity risk. Some of them are given below:

Decline in profits

The decline in profits may be because of several reasons such as the fall in sales volume, fall in prices, loss of goodwill in the market, inability to purchase, and many more. The adverse effects of declining profits pose a cash shortfall and subsequently make it difficult to manage the liquidity crunch. It is necessary to closely monitor any such decline in profits over a short period due to given reasons. It will avoid any losses and solve many issues. Ideally, many problems emerge from this particular problem, so it is a decisive aspect of the manager's efficiency in managing this financial risk and financial obligations.

Inability to collect receivables

Receivables cover a major chunk of the current assets for every kind of entity. History of defaults in the receivables and the inability to make repayment of obligations on time leads to increased costs of borrowings and also degrades the credit rating. Hence, it is pertinent to maintain a healthy credit score so that the banks and financial institutions continue the existing sanctions. The conventional banks will also grant new ones relatively smoothly.

Lack of cash flow management

The lack of management of the current ratio, current assets, and current liabilities enhances potential liquidity issues. Regular comparative analysis of both the inter-firm and intra-firm aspects should be there. Financial risk management should be the survival system rather than the alarm system. The better the liquidity risk exposure management, the better is the overall performance of an entity.

The market liquidity risk factors and the long-term market sentiment also affect the long-term position of an entity. It is the responsibility of the management to manage the assets and liabilities in such a manner so as to ensure a strong financial and cash position in the short term. It is also required to manage it in the long-term as well as to minimize the credit risk and stand shock-proof against the market liquidity risk to the extent possible.

Unexpected economic catastrophe

The dwindling state of the world economy has its effects widespread to every extent possible. History is full of financial crises across the globe. From the Great Depression in 2008 to the sudden outbreak of coronavirus disease in 2019, the world economy has been severely hit since the onset of 2020. It has challenged all the tough world leaders to a great instance making it unbearable for many of the market forces to remain balanced. The stringent negative market sentiment and its continued drag have swept the world of its growth prospects and all the development goals have come to a pause diverting all the possible resources towards survival and recovery. These economic crises have evoked a sudden liquidity risk and have exposed the businesses to a major challenge amid the global crisis.

Unplanned capital transactions

Fixed assets are long-term business assets, that require capital expenditure for acquisition. Capital-intensive industries require huge amounts of capital for every single acquisition. Hence, if the funds are not managed properly the business will run into a liquidity crunch and may experience increased operating leverage which will widen the cash deficit further.

Interpreting liquidity risk indicators

The warning signs of liquidity risk have been already discussed. But just spotting them is not enough, their measurement and interpretation have to be employed in decision making. The prime indicators of liquidity risks and their measurement manner are discussed below:

Ratio analysis

Ratio analysis involves measuring the ratios and interpreting the results by comparative analysis with the industry and with the previous years. The liquidity ratios which provide conclusive evidence of the liquidity position are:

• Current ratio- The current ratio is the ratio of current sources of funds by the current payments and obligations. It is an indicator of the ability of an entity to meet any near-term financial obligation by encashing the current assets held at that time. The best practice in both the banking sector and the common business is that the current ratio must be equal to or more than 1.25 at any given time.

                              $\mathrm{Current} \mathrm{Ratio} = \frac{\mathrm{Total} \mathrm{Current} \mathrm{Assets}}{\mathrm{Total} \mathrm{Current} \mathrm{Liabilities}}$                                                                                                                                                                                                       

• Liquid Ratio- It is the indicator of a business establishment's ability to pay its current liabilities out of its quick assets such as cash, bank, marketable securities, receivables, etc., except inventories. A liquid ratio of more than 1 shows that an entity has enough liquid assets and is in an ideal cash flow position.

                                $\mathrm{Liquid} \mathrm{Ratio} = \frac{(\mathrm{Total} \mathrm{Current} \mathrm{Assets} - \mathrm{Inventories})}{(\mathrm{Total} \mathrm{Current} \mathrm{Liabilities})}$

Cash flow analysis

A cash flow analysis is the careful examination of the cash flows put together in a standard format and forecasts being made for the future based on which capital budget and production planning are based. The cash flow analysis has to be carried out by experts in this field. The cash flow projections should coincide with the strategic objectives and must be reasonable enough to be achievable in the course of its business.

Capital structure requirements

A capital structure must be optimal enough to not become a roadblock in the overall growth of a company. The proportion of debt and equity must be ideal enough according to the business conditions and the interest payment capacity of the entity. A high-interest cost may again lower the profits necessarily.

Islamic banks V/s conventional banks V/s hybrid banks- A special case

There is a higher risk of a liquidity crisis in the case of Islamic banks in comparison to conventional and hybrid banks. The reason is that the Islamic banks generate profits on an equity base and do not involve any interest component. These banks operate on equity and profit-based workings. The risk of liquidity is higher in such cases and hence the default probability is high. However, conventional banks operate on an interest basis. In addition to this, they secure their funds to some extent.

Context and Applications

The liquidity risk exposure is a field of massive expertise and the world's biggest entrepreneurs and regulators consider this parameter as the base of any lending or borrowing decision. The study of this concept is well studied in:

• Chartered Financial Analyst (CFA)
• Bachelors in Finance
• Masters in Finance
• Masters in Business Administration (MBA)

Common Mistakes

While studying the liquidity risk management function, the students must ensure to keep the long-term aspects in parallel attention with the short-term. They should carefully compute the current ratios and liquidity ratios.

Practice Problems

Question 1: Which is the limiting contributor to liquidity?

1. 1. Leverage
   2. Depreciation
   3. Sales
   4. Credit Purchases

Answer: d 

Explanation: Leverage, depreciation, and sales are facilitators of liquidity whereas credit purchases are limiters of liquidity. 

Question 2: Which of the following assets is not considered in the liquid ratio?

1. 1. Inventory
   2. Short-term Loans and Advances
   3. Cash
   4. Bank

Answer: a

Explanation: Inventory is not considered in the numerator while calculating the liquid ratio.

Question 3: What are the implications of a current ratio of 2 and a liquid ratio of 0.25?

1. 1. Lower current liabilities
   2. None of these
   3. Excessive Inventory
   4. The liquid ratio is 1/6 of the current ratio

Answer: c

Explanation: The current ratio and liquid ratio differ mostly because excess inventories are kept.

Question 4: What degrades the credit score?

1. 1. Default in payment
   2. Bankruptcy
   3. Decrease in the sales volume
   4. All of the above

Answer: d

Explanation: The credit score degrades due to the default in payment, bankruptcy, and decrease in the sales volume. Thus, all the factors degrade the credit score.

Question 5: Which of the following functions is not included in liquidity risk management?

1. 1. Cash Budgeting
   2. Receivables Management
   3. Leveraging
   4. Capital Repairs

Answer: d

Explanation: Capital repairs are a part of fixed assets management whereas cash budgeting, receivable management, and leveraging are parts of liquidity risk management.