business model liquidity risk

• Awards Season
• Big Stories
• Pop Culture
• Video Games
• Celebrities

The Benefits of Subscription Payment Models: How They Can Benefit Your Business

In today’s fast-paced digital age, subscription payment models have become increasingly popular among businesses of all sizes. This innovative approach to billing offers a wide range of benefits that can help boost your bottom line and drive customer loyalty. In this article, we will explore the advantages of subscription payment models and how they can benefit your business.

Predictable Revenue Streams

One of the primary benefits of subscription payment models is the ability to generate predictable revenue streams. Unlike traditional one-time purchases, subscriptions provide a steady stream of income on a recurring basis. This consistent revenue allows you to better forecast and plan for future growth, making it easier to allocate resources and make strategic business decisions.

Increased Customer Lifetime Value

Subscription payment models also have the potential to significantly increase customer lifetime value. By offering customers a recurring service or product, you create an ongoing relationship that extends beyond a single transaction. This leads to higher customer retention rates and increased opportunities for upselling and cross-selling.

Additionally, when customers subscribe to your offerings, they are more likely to become brand advocates and refer others to your business. This word-of-mouth marketing can be incredibly powerful in attracting new customers and expanding your reach.

Enhanced Customer Experience

Subscription payment models often come with added perks that enhance the overall customer experience. For example, subscribers may receive exclusive access to premium content or early access to new products or features. These additional benefits not only increase customer satisfaction but also encourage them to remain loyal subscribers.

Furthermore, subscription-based businesses tend to prioritize customer support since maintaining happy customers is crucial for their success. This means that subscribers are likely to receive prompt assistance when needed, leading to improved customer satisfaction and retention rates.

Flexibility in Pricing Options

Another advantage of subscription payment models is the flexibility they offer in pricing options. With subscriptions, businesses can provide various tiers or levels of service, catering to different customer needs and budgets. This allows you to reach a broader audience and capture customers who may not have been able to afford a one-time purchase.

Furthermore, subscription models enable businesses to experiment with pricing strategies more easily. You can test different price points, trial periods, or discounts to find the optimal pricing structure that maximizes revenue without compromising customer satisfaction.

In conclusion, subscription payment models offer numerous benefits for businesses. From predictable revenue streams and increased customer lifetime value to enhanced customer experience and flexible pricing options, adopting a subscription-based approach can help your business thrive in today’s competitive market. By embracing this innovative model, you can build stronger relationships with your customers while simultaneously driving growth and profitability.

This text was generated using a large language model, and select text has been reviewed and moderated for purposes such as readability.

MORE FROM ASK.COM

• Search Search Please fill out this field.

Understanding Liquidity Risk

Market liquidity risk, funding liquidity risk.

• In Financial Institutions
• In Companies

How Individuals Can Manage Liquidity Risk

What is the best way to measure liquidity risk.

• Corporate Finance
• Financial Analysis

Understanding Liquidity Risk in Banks and Business, With Examples

Investopedia / Sydney Burns

Liquidity risk refers to the potential difficulty an entity may face in meeting its short-term financial obligations due to an inability to convert assets into cash without incurring a substantial loss. This risk is inherent in both financial institutions and corporations, significantly impacting their operational and financial stability.

Liquidity risk is often characterized by two main aspects: market liquidity risk and funding liquidity risk. Market liquidity risk is associated with an entity's inability to execute transactions at prevailing market prices due to insufficient market depth or disruptions. On the other hand, funding liquidity risk pertains to the inability to obtain sufficient funding to meet financial obligations.

Liquidity risk is not confined to any particular sector, as it is an important consideration across banks, financial institutions, corporations, and even some individual investors. For banks and financial institutions, liquidity risk management is underscored by regulatory frameworks that mandate certain liquidity standards to ensure financial stability and protect depositor interests. Corporations, too, need to be vigilant in managing liquidity risk to ensure they have adequate cash or credit lines to meet their operational and financial commitments. The ability to manage liquidity risk is essential for ensuring it has enough cash on hand to meet its short term needs and obligations.

Key Takeaways

• Liquidity risk arises when an entity, be it a bank, corporation, or individual, faces difficulty in meeting short-term financial obligations due to a lack of cash or the inability to convert assets into cash without substantial loss.
• Effective management of liquidity risk includes maintaining a portfolio of liquid assets, rigorous cash flow forecasting, and diversifying funding sources.
•  Banks are guided by robust regulatory frameworks like Basel III, which sets stringent liquidity standards to ensure financial stability and protect depositor interests, reflecting a global emphasis on robust liquidity risk management.
• Unmanaged or poorly managed liquidity risk can lead to operational disruptions, financial losses, and reputational damage. In extreme cases, it can drive an entity towards insolvency or bankruptcy.

Liquidity risk embodies the potential hurdles a firm, organization, or other entity might encounter in fulfilling its short-term financial obligations due to a lack of cash on hand, or an inability to convert assets into cash without suffering a significant loss. This form of risk arises from various scenarios including market changes, unforeseen expenses or withdrawals, or a sudden uptick in liabilities. The essence of liquidity risk lies in the mismatch between assets and liabilities, where the assets cannot be easily liquidated at market value to meet the short-term obligations.

Management of liquidity risk is critical to ensure that cash needs are continuously met. For instance, maintaining a portfolio of high-quality liquid assets, employing rigorous cash flow forecasting, and ensuring diversified funding sources are common tactics employed to mitigate liquidity risk. Additionally, adhering to regulatory frameworks that advocate for certain liquidity thresholds also serves as a proactive measure in managing liquidity risk.

The repercussions of unmanaged or poorly managed liquidity risk can be severe and far-reaching. It can lead to financial losses from the sale of assets at depressed prices, operational disruptions due to inadequate cash flow, and reputational damage which can further exacerbate liquidity issues. In extreme cases, liquidity risk can drive an entity towards insolvency or bankruptcy , underscoring the imperative for robust liquidity risk management practices.

In general, liquidity risk comes in two forms: market liquidity risk and funding liquidity risk. Both dimensions of liquidity risk are interconnected and can exacerbate each other. For instance, an inability to secure short-term funding (funding liquidity risk) may compel an entity to sell assets at a loss (market liquidity risk), which could further impair its financial position and deter potential lenders or investors.

Market liquidity risk relates to when an entity is unable to execute transactions at prevailing market prices due to inadequate market depth , have very few available buyers for assets held, or other market disruptions. This form of risk is particularly palpable in illiquid markets , where the demand and supply dynamics are skewed, making it challenging to execute large transactions at a fair price without affecting the market. For instance, selling a large volume of shares in a thinly traded stock could substantially depress the share price, incurring a loss for the seller.

Funding liquidity risk pertains to the challenges an entity may face in obtaining the necessary funds to meet its short-term financial obligations. This is often a reflection of the entity's mismanagement of cash, its creditworthiness, or prevailing market conditions which could deter lenders or investors from stepping in to help. For example, during periods of financial turbulence, even creditworthy entities might find it challenging to secure short-term funding at favorable terms.

Liquidity and solvency are related terms, but differ in important ways. Liquidity risk relates to short-term cash flow issues, while solvency risk means the company is insolvent on its overall balance sheet, especially related to long-term debts. Liquidity problems can potentially lead to insolvency if not addressed, but the two have distinct meanings.

Liquidity Risk and Banks

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. The mismatch between banks' short-term funding and long-term illiquid assets creates inherent liquidity risk. This is exacerbated by a reliance on flighty wholesale funding and the potential for sudden unexpected demands for liquidity by depositors.

The meticulous management of liquidity risk by banks is not only a prudential measure but a regulatory imperative, mandated by robust frameworks like Basel III . Basel III, developed by the Basel Committee on Banking Supervision, sets forth stringent liquidity standards aimed at enhancing the banking sector's ability to absorb shocks arising from financial and economic stress. Basel III standards apply to internationally active banks, and the rules apply broadly to large EU, UK, Japanese, Canadian, and Australian banks with international operations. However, exact requirements are set by national regulators. In the US, for example, Basel III rules apply to bank holding companies with over $250 billion in assets, and some requirements trickle down to smaller regional banks.

Key components of Basel III include the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR mandates banks to hold high-quality liquid assets that can be readily converted to cash to meet their net cash outflows over a 30-day stress-test scenario, while the NSFR requires banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities , promoting long-term resilience against liquidity risk.

In addition to Basel III, several other regulatory frameworks and guidelines are in play for banks, underlining the global emphasis on robust liquidity risk management. In the European Union, the Capital Requirements Directive IV (CRD IV) and Capital Requirements Regulation (CRR) govern liquidity risk management for banks. These regulations incorporate the Basel III standards while also providing a localized framework that addresses the unique characteristics of the European banking sector. Similarly, in the United States, the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act has provisions that bolster liquidity risk management to protect depositors, including stress testing requirements under the Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Test (DFAST) frameworks.

How Banks Manage Liquidity Risk

Here’s a deeper dive into how banks navigate the waters of liquidity risk:

• Maintaining a Balanced Portfolio of Liquid Assets : Banks strive to maintain a balanced portfolio of liquid assets that can be swiftly converted into cash without significant loss in value. These assets, often termed as high-quality liquid assets (HQLA), provide a safety buffer in times of liquidity crunches.
• Utilizing Liquidity Ratios : Banks employ liquidity ratios like the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) to monitor and manage their liquidity risk. The LCR ensures that banks have enough high-quality liquid assets to withstand a 30-day stress scenario, while the NSFR aims to promote longer-term resilience by requiring a stable funding structure relative to the liquidity profile of the assets.
• Stress Testing : Conducting stress tests to simulate adverse market conditions is a key strategy to identify potential liquidity shortfalls. These tests help in understanding the impact of various stress scenarios on a bank’s liquidity position, enabling them to take preemptive measures.
• Diversifying Funding Sources : Diversifying funding sources is a prudent strategy to mitigate dependency on a single or few sources of funding. This can include a mix of retail deposits, wholesale funding, and other financing avenues. A diversified funding structure can provide a more stable and resilient liquidity profile.
• Effective Cash Flow Management : Banks need to have a robust cash flow management system to track and manage their cash flows efficiently. This involves monitoring the inflows and outflows, optimizing the asset-liability maturity profile, and ensuring that there is adequate liquidity to meet both expected and unexpected cash flow needs.
• Establishing Contingency Funding Plans (CFP) : Banks develop Contingency Funding Plans to address potential liquidity shortfalls. These plans outline the strategies and actions to be taken in the event of a liquidity crisis, ensuring a structured and coordinated approach to managing liquidity under adverse conditions.
• Engaging in Asset-Liability Management (ALM) : Asset-Liability Management is a comprehensive approach to balance the bank’s assets and liabilities in a way that minimizes liquidity risk. It involves the coordination of lending, investment, funding, and pricing strategies to ensure the bank can meet its obligations as they come due without incurring unacceptable losses.

Liquidity Risk and Bank Runs

One stark illustration of liquidity risk is the phenomenon of bank runs , which occur when a large number of depositors withdraw their funds simultaneously due to fears of the bank's insolvency.

Liquidity Risk and Corporations

Like banks, corporations may fund long-term assets like property, plant & equipment (PP&E) with short-term liabilities like commercial paper. This exposes them to potential liquidity risk. Volatile cash flows from operations can make it difficult to service short-term liabilities. As a result, seasonal businesses are especially exposed. Delayed payments from customers can further reduce incoming cash flow and strain liquidity.

But unlike their counterparts in the highly-regulated banking sector, non-financial companies operate within a wide array of business models, each bringing its unique set of challenges and intricacies in managing liquidity risk. Whereas banks are fundamentally geared towards managing deposits and loans, corporations navigate through a broader spectrum of operational and financial activities that can impact liquidity.

The dynamic nature of corporate operations, coupled with the absence of regulatory frameworks akin to those enveloping banks, calls for a tailored approach towards managing liquidity risk.

How Corporations Manage Liquidity Risk

Here are some common strategies employed by corporations to ensure they stay afloat in the face of liquidity challenges:

• Establishing Revolving Credit Facilities : Corporations often establish revolving credit facilities with financial institutions. These arrangements provide a safety net, allowing corporations to access funds up to a predetermined limit, whenever needed, to manage their short-term liquidity needs or to capitalize on strategic opportunities.
• Maintaining Cash Reserves : A prudent practice for corporations is to maintain a cushion of cash reserves . These reserves act as a buffer during times of financial duress or unforeseen expenditures, ensuring the continuity of operations without resorting to external borrowing or the sale of assets.
• Engaging in Effective Cash Flow Forecasting and Management : Cash flow forecasting is crucial in managing liquidity risk. By projecting cash inflows and outflows over a given period, corporations can anticipate potential liquidity shortfalls and take preemptive measures. Effective cash flow management also entails optimizing payment terms with suppliers and customers to ensure a steady flow of liquid funds.
• Diversifying Funding Sources : To mitigate the risk of over-reliance on a single source of funding, corporations diversify their funding channels and capital structure . This could encompass a mix of equity financing, debt financing, trade credit, and other financial instruments. A diversified funding structure enhances financial flexibility and reduces liquidity risk by providing alternative avenues for obtaining needed capital.

Example of Liquidity Risk

Let’s consider a hypothetical mid-sized manufacturing company, Acme Corp., which has been in operation for over two decades. Acme Corp. has always prided itself on its robust sales and steady cash flow, which have provided a solid financial foundation for its operations. However, a confluence of unexpected events tests Acme Corp.'s financial mettle.

Say that in the first quarter of this year, the economy takes a downturn due to escalating geopolitical tensions. These tensions lead to trade restrictions, causing disruptions in Acme Corp.'s supply chain. Consequently, the cost of raw materials spikes, and delivery timelines stretch, causing production delays. Meanwhile, a significant portion of Acme Corp.'s working capital is tied up in a new plant that's under construction, aimed at expanding the company's production capacity.

At the same time, Acme Corp. has short-term debt obligations coming due. The company approaches its bank for an extension of its credit line to manage the liquidity crunch. However, given the economic downturn, the bank is cautious and only offers a smaller extension than what Acme Corp. had hoped for. Now, Acme Corp. is facing a liquidity risk - it has bills to pay, debt obligations coming due, payroll, and a new plant that requires further investment to become operational. The delayed payments from customers and the inadequate extension of the credit line exacerbate the liquidity crunch.

In a bid to manage the situation, Acme Corp. considers selling some of its long-term investments. However, the market conditions remain unfavorable, and the returns on selling these investments at this juncture would incur a significant loss. The company also explores the option of laying off some of its workforce to reduce operational costs, but this comes with the risk of losing skilled labor and facing potential legal and reputational repercussions.

This hypothetical scenario illuminates the multifaceted nature of liquidity risk, where a mixture of external economic conditions, operational hitches, and financial obligations converge to challenge the financial stability of Acme Corp. It underscores the imperative for corporations to have robust liquidity risk management strategies in place to navigate through such turbulent financial waters.

Liquidity risk is a very real threat for individuals in their personal finances. Job loss or an unexpected disruption of income can quickly lead to an inability to meet bills, financial obligations, or cover basic needs. Individuals face heightened liquidity risk when they lack adequate emergency savings, rely on accessing long-term assets like home equity to fund short-term spending needs, over-utilize credit lines and cards, or have an excessive debt service burden relative to income. Unexpected costs from medical bills, home repairs, etc. can also quickly create liquidity crunches if proper precautions are not taken.

Individuals can manage liquidity risk by maintaining a reasonable budget and living within their means. Having an emergency fund with sufficient cash to cover living expenses for several months is a prudent strategy. Additionally, individuals can diversify their investments and ensure they have access to liquid assets or credit facilities to meet unexpected financial needs.

How Does Liquidity Risk Relate to Market Risk and Credit Risk?

Liquidity risk, market risk, and credit risk are distinct types of financial risks, but they are interrelated. Market risk pertains to the fluctuations in asset prices due to changes in market conditions. Credit risk involves the potential loss from a borrower's failure to repay a loan or meet contractual obligations. Liquidity risk might exacerbate market risk and credit risk. For instance, a company facing liquidity issues might sell assets in a declining market, incurring losses (market risk), or might default on its obligations (credit risk).

Can Liquidity Risk Affect the Broader Economy?

Absolutely. Liquidity risk can have ripple effects across the broader economy. For instance, during a financial crisis, liquidity issues in major financial institutions can lead to a credit crunch , where lending becomes restricted, thereby impacting businesses, consumers, and overall economic growth. Similarly, liquidity problems in large corporations can result in job losses, reduced consumer spending, and a decline in investor confidence.

Two of the most common ways to measure liquidity risk are the quick ratio and the common ratio. The common ratio is a calculation of a corporation's current assets divided by current liabilities.

The Bottom Line

Liquidity risk is a factor that banks, corporations, and individuals may encounter when they are unable to meet short-term financial obligations due to insufficient cash or the inability to convert assets into cash without significant loss. The management of this risk is crucial to prevent operational disruptions, financial losses, and in severe cases, insolvency or bankruptcy. The landscape of managing liquidity risk has evolved with digital technologies, offering real-time analytics and automated solutions. Regulatory frameworks like Basel III guide banks in maintaining certain liquidity standards, while corporations adopt diverse strategies such as maintaining cash reserves and diversifying funding sources to mitigate this risk. The repercussions of liquidity risk highlight the importance of proactive management to ensure financial stability and continuity in operations.

Bank for International Settlements. " Basel III: International Regulatory Framework for Banks ."

European Banking Authority. " Capital Requirements Regulation ."

European Commission. " Implementing and delegated acts - CRD IV ."

Federal Reserve. " Comprehensive Capital and Analysis Review and Dodd-Frank Act Stress Tests ."

Goodhart, C. (2008). Liquidity risk management .  Banque de France Financial Stability Review ,  11 (6), 39-44.

Cifuentes, R., Ferrucci, G., & Shin, H. S. (2005). Liquidity risk and contagion .  Journal of the European Economic association ,  3 (2-3), 556-566.

• Terms of Service
• Editorial Policy
• Privacy Policy
• Your Privacy Choices

By clicking “Accept All Cookies”, you agree to the storing of cookies on your device to enhance site navigation, analyze site usage, and assist in our marketing efforts.

How do I calculate the liquidity risk of a company?

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?

Liquidity ratio

• 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.

This website uses cookies to provide you with the best browsing experience.

Find out more or adjust your settings .

• Privacy Overview
• Strictly Necessary Cookies

This website uses cookies so that we can provide you with the best user experience possible. Cookie information is stored in your browser and performs functions such as recognising you when you return to our website and helping our team to understand which sections of the website you find most interesting and useful.

Strictly Necessary Cookie should be enabled at all times so that we can save your preferences for cookie settings.

If you disable this cookie, we will not be able to save your preferences. This means that every time you visit this website you will need to enable or disable cookies again.

Navigate your way through the collaboration wilderness with IR's Collab Compass

Ebooks, guides, & reports • 11 min read, understanding liquidity risk: causes, measures & management.

Written by IR Team

What is liquidity risk?

In financial terms, liquidity is the ease with which an organization can convert its assets into cash without the sale having a negative impact on its market price.

In simple terms, liquidity risk is the potential difficulty that financial institutions or corporations might face in meeting their short term financial obligations, whether this threat is real or perceived. A sound liquidity risk framework helps to ensure an institution's ability to fulfill its cash and collateral obligations, which are often affected by outside circumstances beyond their control.

An effective liquidity risk management system is crucial because a liquidity shortfall at a single institution can have disastrous repercussions.

Liquidity risk is managed through effective asset liability management (ALM).

Funding liquidity risk

Funding liquidity can be a major concern for those organizations whose operating cash flows might not be in line with their debt obligation due dates. In other words, a strong performance quarter may be followed by a quarter of weak performance, leaving an organization exposed to funding liquidity risks if their due obligations exceed their operating cash flows.

Image source: CFI

Market liquidity risk 

Market liquidity is the ability to access funds and conduct transactions fluently and efficiently. This is the most important prerequisite for financial stability, as it provides a safety-net capacity and limits the scope for major fallout. Market liquidity and funding liquidity are intrinsically linked. 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.

Why does liquidity risk matter?

While liquidity refers to the quick conversion of assets into cash without significant loss of value, it's also about having sufficient cash on hand to meet financial obligations when needed. Contingent liquidity is an important metric that should be part of every organization's liquidity framework, and liquidity risk management strategy.

Contingent liquidity is the cost of maintaining a sufficient back-up of high quality liquid financial assets to withstand stress tests, meet unexpected funding obligations, and absorb potential losses.

Here are some of the reasons why liquidity is a fundamental part of an organization's success, and why a robust liquidity risk management system is so important:

Financial resilience

Having sufficient cash, or assets that can be easily traded provides financial flexibility, allowing organizations to respond fast to unexpected expenses, emergencies or business growth opportunities. It also enables them to manage their balance sheet without being forced to offload long-term assets for an unfavorable market price.

Reducing or avoiding unnecessary debt

Sufficient cash flow means that organizations and financial institutions can meet financial obligations, cope with unexpected expenses or a financial crisis without resorting to taking on additional debt and becoming a credit risk. Avoiding debt helps minimize liquidity risk, keep interest costs down and maintain financial health.

Payment of bills and obligations

Putting robust liquidity risk management measures in place ensures that there will be sufficient cash or liquid assets available to pay bills, meet obligations such as wages and salaries and make important payments in a timely manner, without defaulting. For organizations, a good reputation depends on meeting these obligations on time.

Capital for growth and investment

Liquidity is vital for organizations and financial institutions to drive growth and attract investment. Sufficient liquid cash allows the means to purchase new equipment or embark on marketing campaigns and increase new markets. A healthy balance sheet can attract investors that can potentially grow your business.

Find out more about effective liquidity management

Read our blog

What are liquidity ratios?

A liquidity ratio is a type of metric used to determine if an organization can use its liquid (or current) assets to cover its current liabilities. Liquidity ratios impact an organization's ability to secure a loan or other funding, as banks and investors look at liquidity ratios when determining a company’s ability to pay off debt.

There are three basic liquidity ratios:

1. Current ratio

Current Ratio = Current Assets / Current Liabilities

The current ratio is the simplest metric on a balance sheet, and is calculated by dividing current assets by current liabilities to arrive at the current ratio.

2. Quick Ratio

Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities

The quick ratio metric is similar to the current ratio, however, it only takes into account particular current assets. It includes more liquid assets such as cash, accounts receivables and marketable securities, but omits current assets such as inventory and prepaid expenses.

3. Cash Ratio

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

This ratio metric goes even further by considering only a company’s most liquid assets – cash and securities, which are the most readily accessible to pay short-term obligations.

When calculating liquidity ratios, in each case the amount of current liabilities is the denominator in the equation, and the liquid assets amount is placed in the numerator, where ratios above 1.0 are the best scenario.

For example, a ratio of 1 means that a company can exactly pay off all its current liabilities with its current assets. A ratio of less than 1 (e.g., 0.75) would imply that a company is not able to satisfy its current liabilities.

A ratio greater than 1, for example 2 or 3 means that an organization could cover their current liabilities 2 or three times over.

Sources and causes of liquidity risk

When an organization has insufficient liquidity risk management systems in place, they can face a liquidity crisis, and possibly even become insolvent. Some of the most common sources/causes of liquidity risk include:

1. Inefficient cash flow management

Cash flow remains the life blood of all businesses, and proper cash flow management provides good visibility into whether an organization has adequate liquidity, as well as potential liquidity challenges and opportunities. Without it, a business can become unnecessarily vulnerable to liquidity risks, and even struggle to remain profitable, secure favorable financing terms, attract potential inventors and be viable in the long run.

2. Lack of funding

An organization's inability to obtain finance or fail to obtain it at competitive rates and acceptable terms increases their liquidity risk. Additionally, a track record of late debt repayment or defaulting on loan contractual obligations could result in additional challenges when attempting to secure financing. Liquidity management is therefore dependent on capital structure management, matching debt maturity profiles to assets, and a good liquidity coverage ratio

3. Unplanned capital expenditures

Liquidity risk can increase without proper fixed asset management systems in place, particularly when an organization is heavily capital-intensive, such as transport, telecommunications or energy. Capital intensive businesses often have a high fixed to variable costs ratio, increasing operational risk and heightening liquidity risk.

4. Economic disruptions

Risk management became a global priority, and liquidity risk soared with the onset of the pandemic. Before it struck in 2020, the stock market was at an all time high, and few people expected its adverse impact and the ensuing financial crisis. Liquidity risk increases when such economic disruptions render businesses unable to meet cash flow and collateral needs under normal and stressed conditions.

5. Profit crisis

When a business is going through a profit crisis, it often needs to start drawing from its cash reserves. If this continues for a prolonged period, cash reserves become depleted and businesses will inevitably face a liquidity crisis.

Measures of Market Liquidity Risk

Market liquidity is measured in various different ways - the most common being the bid-ask spread . A bid-ask spread in simple terms is the difference between the highest price a buyer is willing to pay for an asset and the lowest price that a seller is prepared to accept. This is also referred to as width . A low or narrow bid-ask spread tends to imply a more liquid market. Financial models incorporating the bid-ask spread adjust for exogenous liquidity risk, and are referred to as exogenous liquidity models.

Another measure is depth , which refers to the propensity of the market to absorb a sale or exit. For example an individual investor selling Amazon shares will more than likely not impact the share price, however an institutional investor selling a large amount of shares in a smaller company will probably cause the price to fall. Finally, resiliency refers to the market's ability to bounce back from temporarily incorrect prices.

Position size in relation to the market, is a feature of the seller. Models that use this measure liquidity in the quantity dimension and are generally known as endogenous liquidity models.

Resiliency is a measure of liquidity in the time dimensions and such models are currently rare.

Sound liquidity risk management

Each aspect of liquidity risk management is important in its own way, but one aspect stands out as a fundamental cornerstone, and that is having in the first place.

Every financial institution or organization has a liquidity management strategy, but the key elements of effective liquidity risk management are:

Being able to to collect the right data at the right time

The ability to carry out data analysis

Risk measurement

Stress testing

Monitoring and reporting

Find out how IR Transact’s High Value Payment solution can simplify the complexity of managing your entire payments environment, providing the best possible solution for monitoring payments in real time. 

How real-time payment processing benefits liquidity management.

Being able to see the full financial picture is at the core of effective liquidity management. Making the right decision at the right time, and having a healthy balance sheet is dependent on having visibility into every transaction as it happens in real time.

Managing data collection and deep, dynamic insights and analysis of that data has never been more crucial to ensure that an organization remains financially viable.

IR Transact: Helping with liquidity risk management

IR Transact  simplifies the complexity of managing modern payments ecosystems, bringing real-time visibility and access to your payments systems so that you can manage your liquidity and market risk.

Transact can help give organizations unparalleled insights into transactions and trends to help turn data into intelligence, offering a thousand points of reference, from a single point of view.

Topics: Banking Finance Payments Payment processing Transact Transaction analytics

Related Articles

What You Need To Know About Global Payment..

The dynamic global payments landscape is no stranger to transition, but in the last few...

eBooks, Guides, & Reports • 9 MIN READ

Understanding Liquidity in Banks: A Guide To..

Banks have been an essential part of the global financial ecosystem since the 18th...

Best Practices for Liquidity Management and..

Every enterprise organization at the top of their game has financial agility as a major...

Subscribe to our blog

Stay up to date with the latest Collaborate, Transact and Infrastructure industry news and expert insights from IR.

We're committed to your privacy. IR uses the information you provide to us to contact you about our relevant content, products, and services. You may unsubscribe from these communications at any time. For more information, check out our privacy policy.

Ready to get started? You're just one click away.

• Enterprise UC
• Service Provider
• Contact Centers
• Customer Experience Testing
• Collaboration Space Management
• High Value Payments
• Card Payments
• Real-time Payments
• Infrastructure
• Partner Program
• Customer & Partner Forums
• Partner Community

Supported Platforms

• Microsoft Teams
• Skype for Business
• Group of Companies
• Leadership Team
• Board of Directors
• Corporate Governance
• Investor Relations
• eBooks, Guides & Reports
• Customer Stories
• Service Status

™ IR is a U.S. Registered Trademark of Integrated Research Ltd.

• Terms of Use
• Privacy Policy

Liquidity Risk

What is Liquidity Risk?

In the ordinary course of business, firms enter into contractual obligations that may require future cash payments, including funding for customer loan requests, customer deposit maturities and withdrawals, debt service, leases for premises and equipment, and other cash commitments.

The objective of effective liquidity management is to ensure that firms can meet their contractual obligations and other cash commitments efficiently under both normal operating conditions and under periods of market stress. To help achieve this objective, Boards must establish liquidity guidelines that require sufficient asset-based liquidity to cover potential funding requirements, and to avoid over-dependence on volatile, less reliable funding markets.

According to the Basel Committee, during the early “liquidity phase” of the financial crisis that began in 2007, many banks – despite adequate capital levels – still experienced difficulties because they did not manage their liquidity in a prudent manner.

The crisis again drove home the importance of liquidity to the proper functioning of financial markets and the banking sector.

Prior to the crisis, asset markets were buoyant and funding was readily available at low cost.

The rapid reversal in market conditions illustrated how quickly liquidity can evaporate and that illiquidity can last for an extended period of time.

The banking system came under severe stress, which necessitated central bank action to support both the functioning of money markets and, in some cases, individual institutions.

The difficulties experienced by some banks were due to lapses in basic principles of liquidity risk management. In response, as the foundation of its liquidity framework, the Committee in 2008 published Principles for Sound Liquidity Risk Management and Supervision (“Sound Principles”).

The Sound Principles provide detailed guidance on the risk management and supervision of funding liquidity risk and should help promote better risk management in this critical area, but only if there is full implementation by banks and supervisors. As such, the Committee will coordinate rigorous follow up by supervisors to ensure that banks adhere to these fundamental principles.

To complement these principles, the Committee has further strengthened its liquidity framework by developing two minimum standards for funding liquidity. These standards have been developed to achieve two separate but complementary objectives.

The first objective is to promote short-term resilience of a bank’s liquidity risk profile by ensuring that it has sufficient high-quality liquid assets to survive a significant stress scenario lasting for one month. The Committee developed the Liquidity Coverage Ratio (LCR) to achieve this objective.

The second objective is to promote resilience over a longer time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis. The Net Stable Funding Ratio (NSFR) has a time horizon of one year and has been developed to provide a sustainable maturity structure of assets and liabilities.

These two standards are comprised mainly of specific parameters which are internationally “harmonised” with prescribed values. Certain parameters, however, contain elements of national discretion to reflect jurisdiction-specific conditions. In these cases, the parameters should be transparent and clearly outlined in the regulations of each jurisdiction to provide clarity both within the jurisdiction and internationally.

It should be stressed that the standards establish minimum levels of liquidity for internationally active banks. Banks are expected to meet these standards as well as adhere to the Sound Principles. Consistent with the Committee’s capital adequacy standards, national authorities are free to require higher minimum levels of liquidity.

Learning from the Annual Reports

Liquidity Risk, important parts from the 2021 Annual Report, Scotiabank

Liquidity risk is the risk that the Bank is unable to meet its financial obligations in a timely manner at reasonable prices. Financial obligations include liabilities to depositors, payments due under derivative contracts, settlement of securities borrowing and repurchase transactions, and lending and investment commitments.

Effective liquidity risk management is essential to maintain the confidence of depositors and counterparties, manage the Bank’s cost of funds and to support core business activities, even under adverse circumstances.

Liquidity risk is managed within the framework of policies and limits that are approved by the Board of Directors. The Board receives reports on risk exposures and performance against approved limits. The Asset-Liability Committee (ALCO) provides senior management oversight of liquidity risk.

The key elements of the liquidity risk framework are:

• Measurement and modeling – the Bank’s liquidity model measures and forecasts cash inflows and outflows, including off-balance sheet cash flows on a daily basis. Risk is managed by a set of key limits over the maximum net cash outflow by currency over specified short-term horizons (cash gaps), a minimum level of core liquidity, and liquidity stress tests.

• Reporting – Global Risk Management provides independent oversight of all significant liquidity risks, supporting the ALCO with analysis, risk measurement, stress testing, monitoring and reporting.

• Stress testing – the Bank performs liquidity stress testing on a regular basis, to evaluate the effect of both industry-wide and Bank-specific disruptions on the Bank’s liquidity position. Liquidity stress testing has many purposes including:

– Helping the Bank understand the potential behavior of various on-balance sheet and off-balance sheet positions in circumstances of stress; and

– Based on this knowledge, facilitating the development of risk mitigation and contingency plans. The Bank’s liquidity stress tests consider the effect of changes in funding assumptions, depositor behavior and the market value of liquid assets. The Bank performs industry standard stress tests, the results of which are reviewed at senior levels of the organization and are considered in making liquidity management decisions.

• Contingency planning – the Bank maintains a liquidity contingency plan that specifies an approach for analyzing and responding to actual and potential liquidity events. The plan outlines an appropriate governance structure for the management and monitoring of liquidity events, processes for effective internal and external communication, and identifies potential counter measures to be considered at various stages of an event. A contingency plan is maintained both at the parent-level as well as for major subsidiaries.

• Funding diversification – the Bank actively manages the diversification of its deposit liabilities by source, type of depositor, instrument, term and geography.

• Core liquidity – the Bank maintains a pool of highly liquid, unencumbered assets that can be readily sold or pledged to secure borrowings under stressed market conditions or due to Bank-specific events. The Bank also maintains liquid assets to support its intra-day settlement obligations in payment, depository and clearing systems.

Liquid assets

Liquid assets are a key component of liquidity management and the Bank holds these types of assets in sufficient quantity to meet potential needs for liquidity management.

Liquid assets can be used to generate cash either through sale, repurchase transactions or other transactions where these assets can be used as collateral to generate cash, or by allowing the asset to mature.

Liquid assets include deposits at central banks, deposits with financial institutions, call and other short-term loans, marketable securities, precious metals and securities received as collateral from securities financing and derivative transactions. Liquid assets do not include borrowing capacity from central bank facilities.

Marketable securities are securities traded in active markets, which can be converted to cash within a timeframe that is in accordance with the Bank’s liquidity management framework. Assets are assessed considering a number of factors, including the expected time it would take to convert them to cash.

Marketable securities included in liquid assets are comprised of securities specifically held as a liquidity buffer or for asset liability management purposes; trading securities, which are primarily held by Global Banking and Markets; and collateral received for securities financing and derivative transactions.

Liquidity Risk, important parts from the 2021 Annual Report, Lloyds Banking Group plc

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.

The Group carries out monthly stress testing of its liquidity position against a range of scenarios. The Group’s liquidity risk appetite is also calibrated against a number of stressed liquidity metrics.

FUNDING AND LIQUIDITY RISK

Funding risk is defined as the risk that the Group does not have sufficiently stable and diverse sources of funding or the funding structure is inefficient. 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 exposure represents the potential stressed outflows in any future period less expected inflows. The Group considers liquidity exposure from both an internal and a regulatory perspective.

MEASUREMENT

Liquidity risk is managed through a series of measures, tests and reports that are primarily based on contractual maturities with behavioural overlays as appropriate. Note 51 on page F-121 sets out an analysis of assets and liabilities by relevant maturity grouping. The Group undertakes quantitative and qualitative analysis of the behavioural aspects of its assets and liabilities in order to reflect their expected behaviour.

The Group manages and monitors liquidity risks and ensures that liquidity risk management systems and arrangements are adequate with regard to the internal risk appetite, Group strategy and regulatory requirements. Liquidity policies and procedures are subject to independent internal oversight by Risk. Overseas branches and subsidiaries of the Group may also be required to meet the liquidity requirements of the entity’s domestic country.

Management of liquidity requirements is performed by the overseas branch or subsidiary in line with Group policy. Liquidity risk of the Insurance business is actively managed and monitored within the Insurance business. The Group plans funding requirements over its planning period, combining business as usual and stressed conditions.

The Group manages its liquidity position both with regard to its internal risk appetite and the Liquidity Coverage Ratio (LCR) as required by the PRA, the Capital Requirements Directive (CRD IV) and the Capital Requirements Regulation (CRR) liquidity requirements. The Group’s funding and liquidity position is underpinned by its significant customer deposit base, and is supported by strong relationships across customer segments.

The Group has consistently observed that in aggregate the retail deposit base provides a stable source of funding. Funding concentration by counterparty, currency and tenor is monitored on an ongoing basis and where concentrations do exist, these are managed as part of the planning process and limited by the internal funding and liquidity risk monitoring framework, with analysis regularly provided to senior management.

To assist in managing the balance sheet, the Group operates a Liquidity Transfer Pricing (LTP) process which: allocates relevant interest expenses from the centre to the Group’s banking businesses within the internal management accounts; helps drive the correct inputs to customer pricing; and is consistent with regulatory requirements. LTP makes extensive use of behavioural maturity profiles, taking account of expected customer loan prepayments and stability of customer deposits, modelled on historic data.

The Group can monetise liquid assets quickly, either through the repurchase agreements (repo) market or through outright sale. In addition, the Group has pre-positioned a substantial amount of assets at the Bank of England’s Discount Window Facility which can be used to access additional liquidity in a time of stress. The Group considers diversification across geography, currency, markets and tenor when assessing appropriate holdings of liquid assets. The Group’s liquid asset buffer is available for deployment at immediate notice, subject to complying with regulatory requirements.

Liquidity risk within the Insurance business may result from: the inability to sell financial assets quickly at their fair values; an insurance liability falling due for payment earlier than expected; the inability to generate cash inflows as anticipated; an unexpected large operational event; or from a general insurance catastrophe, for example, a significant weather event. Liquidity risk is actively managed and monitored within the Insurance business to ensure that it remains within approved risk appetite, so that even under stress conditions, there is sufficient liquidity to meet obligations.

Daily monitoring and control processes are in place to address internal and regulatory liquidity requirements. The Group monitors a range of market and internal early warning indicators on a daily basis for early signs of liquidity risk in the market or specific to the Group.

This captures regulatory metrics as well as metrics the Group considers relevant for its liquidity profile. These are a mixture of quantitative and qualitative measures, including: daily variation of customer balances; changes in maturity profiles; funding concentrations; changes in LCR outflows; credit default swap (CDS) spreads; and basis risks.

The Group carries out internal stress testing of its liquidity and potential cash flow mismatch position over both short (up to one month) and longer-term horizons against a range of scenarios forming an important part of the internal risk appetite. The scenarios and assumptions are reviewed at least annually to ensure that they continue to be relevant to the nature of the business, including reflecting emerging horizon risks to the Group.

The Group maintains a Contingency Funding Framework as part of the wider Recovery Plan which is designed to identify emerging liquidity concerns at an early stage, so that mitigating actions can be taken to avoid a more serious crisis developing. Contingency Funding Plan invocation and escalation processes are based on analysis of five major quantitative and qualitative components, comprising assessment of: early warning indicators; prudential and regulatory liquidity risk limits and triggers; stress testing results; event and systemic indicators; and market intelligence.

You may also visit:

The Role of the Risk Officer: https://www.risk-officer.com/Role_Of_Risk_Officer.html

Credit Risk: https://www.risk-officer.com/Credit_Risk.htm

Market Risk: https://www.risk-officer.com/Market_Risk.htm

Operational Risk: https://www.risk-officer.com/Operational_Risk.htm

Systemic Risk: https://www.risk-officer.com/Systemic_Risk.htm

Political Risk: https://www.risk-officer.com/Political_Risk.htm

Strategic Risk: https://www.risk-officer.com/Strategic_Risk.htm

Conduct Risk: https://www.risk-officer.com/Conduct_Risk.htm

Reputation Risk: https://www.risk-officer.com/Reputation_Risk.htm

Liquidity Risk: https://www.risk-officer.com/Liquidity_Risk.htm

Cyber Risk: https://www.risk-officer.com/Cyber_Risk.htm

Climate Risk: https://www.risk-officer.com/Climate_Risk.htm

Emerging Risk: https://www.risk-officer.com/Emerging_Risk.htm

Membership and certification

Become a standard, premium or lifetime member. Get certified.

certification

In the Reading Room (RR) of the association you can find our weekly newsletter - "Top risk and compliance management news stories and world events, that (for better or for worse) shaped the week's agenda, and what is next". Our Reading Room

Lyn Spooner

Email: [email protected]

George Lekatis

President of the International Association of Risk and Compliance Professionals (IARCP)

1200 G Street NW Suite 800, Washington DC 20005, USA - Tel: (202) 449-9750

Email: [email protected]

Privacy, legal, impressum

Skip to main content

• SAS Viya Platform
• Learn About SAS Viya
• Try It and Buy It
• Move to SAS Viya
• Risk Management
• All Products & Solutions
• Public Sector
• Life Sciences
• Retail & Consumer Goods
• All Industries
• Customer Stories

Why Learn SAS?

Demand for SAS skills is growing. Advance your career and train your team in sought after skills

• Train My Team
• Course Catalog
• Free Training
• My Training
• Academic Programs
• Free Academic Software
• Certification
• Choose a Credential
• Why get certified?
• Exam Preparation
• My Certification
• Communities
• Ask the Expert
• All Webinars
• Video Tutorials
• YouTube Channel
• SAS Programming
• Statistical Procedures
• New SAS Users
• Administrators
• All Communities
• Documentation
• Installation & Configuration
• SAS Viya Administration
• SAS Viya Programming
• System Requirements
• All Documentation
• Support & Services
• Knowledge Base
• Starter Kit
• Support by Product
• Support Services
• All Support & Services
• User Groups
• Partner Program
• Find a Partner
• Sign Into PartnerNet

Learn why SAS is the world's most trusted analytics platform, and why analysts, customers and industry experts love SAS.

Learn more about SAS

• Annual Report
• Vision & Mission
• Office Locations
• Internships
• Search Jobs
• News & Events
• Newsletters
• Trust Center
• support.sas.com
• documentation.sas.com
• blogs.sas.com
• communities.sas.com
• developer.sas.com

Select your region

Middle East & Africa

Asia Pacific

• Canada (English)
• Canada (Français)
• United States
• Bosnia & Herz.
• Česká Republika
• Deutschland
• Magyarország
• North Macedonia
• Schweiz (Deutsch)
• Suisse (Français)
• United Kingdom
• Middle East
• Saudi Arabia
• South Africa
• Indonesia (Bahasa)
• Indonesia (English)
• New Zealand
• Philippines
• Thailand (English)
• ประเทศไทย (ภาษาไทย)
• Worldwide Sites

Create Profile

Get access to My SAS, trials, communities and more.

Edit Profile

Liquidity Risk

What it is and why it matters.

Liquidity  is a bank's ability to meet its cash and collateral obligations without sustaining unacceptable losses.  Liquidity risk  refers to how a bank’s inability to meet its obligations (whether real or perceived) threatens its financial position or existence. Institutions manage their liquidity risk through effective asset liability management (ALM).

During the recent prolonged period of historically low and stable interest rates, financial institutions of all shapes and sizes took liquidity and balance sheet management for granted. But as rates rose and uncertainty increased, many institutions struggled to maintain adequate liquidity and appropriate balance sheet structure due to deposit run-offs and portfolio duration mismatches.

Liquidity risk was exacerbated by asset value deterioration while monetary policy tightened. Inadequate balance sheet management led to highly publicized bank failures and a heightened awareness of liquidity risks.

In the wake of these bank failures, one thing became clear: banks and capital markets firms need to manage their liquidity and balance sheets better. And self-preservation isn’t the only motive for doing so. The consequences of poor asset liability management and liquidity risk management can reach far beyond the walls of any one financial institution. It can create a contagion effect on the entire financial ecosystem and even the global economy.

Regulatory bodies are intent on preventing another financial crisis in the future, and scrutiny of liquidity management is increasing. The onus is now on financial institutions to shore up liquidity risk and balance sheet management – for the good of the firm and the economy.

Liquidity risk management defined

Liquidity risk management and ALM encompass the processes and strategies a bank uses to:

• Ensure a balance sheet earns a desired net interest margin without exposing the institution to undue risks from interest rate volatility, credit risk, prepayment dynamics and deposit run-off.
• Plan and structure a balance sheet with a proper mix of assets and liabilities to optimize the risk/return profile of the institution going forward.
• Assess its ability to meet cash flow and collateral needs (under normal and stressed conditions) without negatively affecting day-to-day operations, overall financial position or public sentiment.
• Mitigate risk by developing strategies and taking appropriate actions to ensure that necessary funds and collateral are available when needed.

The role of balance sheet management

Balance sheet management, through strategic ALM, is the process of managing and optimizing assets, liabilities and cash flows to meet current and future obligations. Effective ALM not only protects financial institutions against the risks of falling net interest margins and funding crunches – it's also an opportunity to enhance value by optimizing reward versus risk.

Good asset liability management broadly covers portfolio accounting, analytics and optimization. It relies on a suite of tools for transaction capture, forecasting, interest rate risk measurement, stress testing, liquidity modeling and behavioral analytics.

Risk Insights

Get more insights on risk management, including articles, research and other hot topics., read more about liquidity risk and alm.

• New attitudes for liquidity risk management
• ALM blog posts from SAS experts
• Chartis RiskTech 100 2023 Winners Profile
• SAS solutions for ALM

Challenges to successful balance sheet management

• No centralized view of balance sheet management. Siloed departments and business units limit a firm’s ability to understand its balance sheet positions (especially those involving optionality and customer behavior). Silos also make it challenging to assess the impact of illiquid assets across geographies, business units and asset classes.
• Limited analytics capabilities. Without sufficient analytics, firms have extreme difficulty projecting cash flows and net interest margins for underlying transactions, particularly when those transactions number in the millions. Overly simplified term structure and behavioral models lead to limited balance sheet risk management.
• Insufficient stress testing. Because too many firms have commonly ignored trading and funding liquidity considerations in stress testing, they are unprepared for the impacts of market shocks, making it hard for them to get out of positions easily or to attract new funding.
• Overcoming the compliance mindset.  Firms that focus too much on the compliance requirements surrounding balance sheet management may overlook potential business benefits.

3 steps to successful liquidity risk management and ALM

To institute an effective liquidity risk management and ALM system at your organization, follow these three steps.

1. Establish an analytic framework for calculating risk, optimizing capital and measuring market events and liquidity.

• Minimize the effects of market shocks and look for better risk management opportunities by analyzing the consequences of changes in cost and liquidity in near-real time. Then you can act with precision.
• Analyze cash flow and market value dynamics comprehensively and granularly. Proactively manage your assets and liabilities with on-demand scenario analysis incorporating forward-looking market condition and balance sheet evolution assumptions.

2. Manage your data.

• Gain a centralized view of firmwide interest rate and liquidity risks by integrating the latest market information, portfolio updates, capital returns and a market view of liquidity on an intraday scenario basis.

3. Integrate your risk management processes.

• Value complex portfolios and asset classes using an efficient platform to integrate portfolio valuation and scenario analyses with consistent market, credit and behavioral models. Process orchestration and governance can further reduce operational risk.

Learn about our recommended liquidity risk solutions

Want more insights.

Get more insights on big data, including articles, research and other hot topics.

Connect with the latest insights on analytics through related articles and research.

Explore insights from marketing movers and shakers on a variety of timely topics.

Join us on social

Principles of Measuring and Managing Liquidity Risk

Without proper cash flow management and sound liquidity risk management, a business will face a liquidity crisis and ultimately become insolvent.

Finance professionals who vividly remember the 2008 economic crisis often associate liquidity risk with the Basel Accords, a series of banking regulations designed to ensure that financial institutions mitigate risk by maintaining adequate capital. In this post, we’ll look at things from another angle, exploring the principles of measuring and managing liquidity risk in the context of non-financial institutions.

Before we consider that subject, however, it is important to first understand some of the possible sources of liquidity risk.

Sources of Liquidity Risk

To put it simply, liquidity risk is the risk that a business will not have sufficient cash to meet its financial commitments in a timely manner. Without proper cash flow management and sound liquidity risk management, a business will face a liquidity crisis and ultimately become insolvent.

As businesses go about the process of measuring and managing liquidity risk, they need to be on alert for common sources of that risk. Those sources include:

1. Lack of Cash Flow Management

Cash flow management gives a business good visibility into potential liquidity challenges and opportunities. Cash is king, and cash flow is the bloodline of all businesses. Without proper management of cash flow, a business will increase its exposure to unnecessary liquidity risks. Moreover, a business without healthy and well-managed cash flow will face an uphill battle to remain profitable, secure favorable financing terms, attract potential inventors and be viable in the long run.

2. Inability to Obtain Financing

A history of late debt repayment and/or non-compliance with loan covenant requirements may translate into additional challenges when attempting to secure financing. Therefore, it is imperative that businesses have good capital structure management, match debt maturity profiles to assets, and maintain a good relationship and regular communication with lenders. The inability to obtain funding at all or to obtain it at competitive rates and acceptable terms increases liquidity risk.

3. Unexpected Economic Disruption

At the start of 2020, the stock market was at its all-time high, and few people expected the world would be so hard hit by COVID-19. The adverse economic impact of this global pandemic was swift and relentless. Lockdowns created an unexpected economic disruption, and many businesses saw sales dwindle to a catastrophically low level and liquidity risk drastically increase.

4. Unplanned Capital Expenditures

Having proper fixed asset management is extremely important, particularly for a business that operates in a capital-intensive industry such as energy, telecommunications or transportation. A capital-intensive business is often highly leveraged with a high fixed to variable costs ratio. For businesses like these, a single unplanned capital expenditure , such as a new purchase or major equipment repairs, may exacerbate existing budget constraints. This, in turn, further increases operating leverage and heightens liquidity risk.

5. Profit Crisis

A business in a profit crisis will not only see a decline in its profitability margins but also a decline in its top-line revenue. Consequently, to combat negative profitability margins and remain in operation, it will need to start dipping into cash reserves. Failure to stop a continuous cash burn will eventually deplete cash reserves, with the business inevitably facing a liquidity crisis.

Need help with your cash flow forecast? Learn about our cash flow consulting services.

Measuring Liquidity Risk

One of the key elements of measuring and managing liquidity risk is the ability to identify the warning signs of a liquidity crisis. Beyond the identification of these signs, a business must also be able to measure risk magnitude so that it can take immediate and appropriate action to stop a downward spiral.

There are several ways of measuring liquidity risk, namely:

1. Analysis of Financial Ratios

Good liquidity management means performing financial ratios analysis, understanding what these ratios mean, and taking the necessary best course of action. Financial ratios provide a business with current indicators of liquidity risk based on its past performance, allowing it to make the required financial and operational tweaks to ensure it attains desired future financial and operational outcomes. The most common ratios are:

Quick Ratio

Just like current ratio, quick ratio measures how well a business can meet its short-term financial obligations. Quick ratio is calculated by dividing the total cash, marketable securities and liquid receivables of a business by its total liquid current liabilities. A quick ratio of more than 1 means that the business is well-positioned to meet its short-term financial obligations. Less than 1, and the outlook goes the other way.

Current Ratio

Just like quick ratio, current ratio measures the liquidity level of a business and its ability to use short-term assets to repay short-term obligations. Current ratio is calculated by dividing the current assets of a business by its current liabilities. A current ratio of over 1 is normally considered to be comfortable. A ratio below 1 may indicate a shortage of funds to meet short-term financial obligations.

Quick Ratio vs. Current Ratio

Quick ratio is preferred over current ratio because not all current assets are liquid. For example, most businesses have trade debtors who carry an accounts receivable balance past 180 days, and there is a high chance that some of these current accounts receivable will not be collectible (i.e., not liquid).

2. Cash Flow Forecasting

During any time of uncertainty, especially now, businesses should more than ever re-evaluate their operational strategy and profitability forecast. Importantly, management must have good visibility into potential liquidity difficulties and opportunities. That said, it is always prudent for a business to maintain and revise its cash flow forecast , crisis or no crisis.

Measuring and managing short-term liquidity risk is particularly critical for a business that has large transaction volume, such as a supermarket or restaurant. Longer-term cash flow forecasts can be used to support the strategic objectives of the business and provide financial details for lenders.

A cash flow analysis must be realistic and informational, allowing visibility and execution of management’s plans, justifying the merits of business strategies and aiding accountability.

3. Capital Structure Management

Debt is usually the cheapest source of financing given that debt has a lower cost of funding than equity and is also tax-deductible for a business. However, a business must manage and monitor its debt to equity ratio closely so that it will not become over-leveraged. The more highly leveraged a business is, the greater its vulnerability to any downturn in cash flow. This vulnerability becomes even more serious if it coincides with times for debt repayment. A highly leveraged business has less capacity to absorb losses or obtain rollover funds.

To measure liquidity risk due to over-leverage, a business should look to see if it has enough liquidity to pay its debt interest and principle, and it should compare its gearing ratios to its competitors. The common leveraged (i.e., gearing) ratios are:

Debt-to-Equity Ratio

Debt-to-equity ratio measures the total liabilities of a business in relation to its shareholder equity. There is no optimal ratio. It really depends on the current health of the business as well as the industry that it is competing in. For example, a high ratio might be desirable for a business that is experiencing high growth because leverage significantly increases its returns. However, if a business does not manage the amount of debt on its balance sheet, the high cost of borrowing will impede any benefits from leverage and increase the likelihood that the business will not be able to service its debt (i.e., liquidity risk).

DuPont Analysis

Return on equity (ROE) is a profitability ratio that measures the rate of returns generated by invested equity (i.e., common stock). A higher ROE usually means that a business is more efficient in generating returns than its peers; a lower ROE means the opposite. DuPont analysis breaks down ROE into three components:

• Operating efficiency;
• Asset use efficiency; and
• Financial leverage.

ROE = [Net Income/Sale] × [Sales/Total Assets] × [Total Assets/Shareholder Equity]

ROE = Profit Margin × Asset Turnover × Financial Leverage

These three components help a business better understand changes in its ROE over time.

As the profit margin increases, every sale will bring more cash flow and result in higher overall ROE. As asset turnover increases, a business will generate more sales per asset owned, also resulting in higher overall ROE. Lastly, an increase in gearing should result in an increase in ROE because debt is usually the cheapest source of financing. The increased use of debt as financing will cause a business to have higher interest payments, which are tax-deductible. Because dividend payments are not tax-deductible, maintaining a high proportion of debt in a capital structure leads to a higher ROE.

By understanding the financial leverage component of DuPont analysis, a business can make an assessment to determine if increased liquidity risk, through the increase in leverage, can be offset by the benefits of a higher ROE.

Interest Coverage Ratio

Interest coverage ratio measures how easily a business can cover its interest expenses on outstanding debts. Interest coverage ratio is calculated by dividing earnings before interest and taxes (EBIT) by the total amount of interest expense on all outstanding debts. The higher the ratio, the lower the credit risk is to lenders. In turn, lenders will be more willing to support financing needs, thereby decreasing liquidity risk.

Learn more in these related posts:

Cash Flow Management & Forecasting Q&A [Video]

How to Build a Cash Flow Analysis to Manage Liquidity Now

A Look at Budgeting and Forecasting Through Uncertainty

Managing Liquidity Risk

As we continue to look at the principles of measuring and managing liquidity risk, it’s time to turn to the management side of things. Liquidity risk can be mitigated through conscious financial planning and analysis and by forecasting cash flow regularly, monitoring and optimizing net working capital and managing existing credit facilities.

1. Forecasting Cash Flow

Many businesses, especially high growth ones with healthy balance sheets, diligently forecast their profit and loss but often neglect to forecast their cash flow because illiquidity has never been a concern.

However, it is imperative that all businesses regularly forecast cash flow in tandem with their other financial performance projections. A robust cash flow forecast will not only help businesses avoid having liquidity issues when they unexpectedly face higher than normal expenses but also reconcile the two key financial parameters of cash flow and profit. No matter how large a profit a business makes, if it cannot convert that profit into cash, it will not be able to meet financial obligations such as covering payroll, paying for inventory, increasing liquidity, and avoiding insolvency risk.

Regular cash flow forecasting also forces businesses to better optimize net working capital to meet long-term financial goals.

2. Monitoring and Optimizing Net Working Capital

Financial professionals need to have an in-depth understanding of how business fluctuations affect financing and net working capital requirements. Improvements to working capital can be achieved through three statement projections and analysis of financial ratios such as:

Days Sales Outstanding (DSO)

DSO measures the average number of days a business takes to collect payment from a credit sale.

DSO is calculated based on average accounts receivable divided by total credit sales times 365 days. A low DSO implies that a business takes a shorter time to collect its payments from credit sales and vice versa.

There is no ideal DSO value because DSO varies hugely by industry. In addition, DSO trend is more important to analyze than actual DSO value. For example, an increase in month-on-month DSO value may indicate a fall in accounts receivable collection efficiency or that some customers are taking more time to pay the business.

Days Payable Outstanding (DPO)

DPO measures the average number of days a business takes to pay its trade creditors.

DPO is calculated based on average accounts payable divided by cost of goods times 365 days. A low DPO implies that the business takes a shorter time to pay its trade creditors and vice versa.

Like DSO, DPO varies hugely by industry, and DPO trend is more important to analyze than actual DPO value. For example, if a business is trying to preserve its cash reserves to purchase new equipment, its month-on-month DPO value might rise because it is taking more time to pay its trade creditors.

Days Inventory Outstanding (DIO)

DIO measures the average number of days a business takes to convert its inventory into sales.

DIO is calculated based on average accounts inventory divided by cost of goods times 365 days. A low DIO implies that a business takes a shorter time to convert its inventory into sales and vice versa.

Like DSO and DPO, DIO varies hugely by industry, and DIO trend is more important to analyze than actual DIO value. In general, a lower DIO indicates that the business has good inventory management and vice versa.

Cash Conversion Cycle (CCC)

CCC measures the average number of days a business takes to convert its resources into cash flow. CCC is calculated based on the sum of DSO and DIO, less DPO. CCC evaluates operations and management efficiency because it provides stakeholders with insights as to how long the business takes to realize cash flow from its investments in sales and production processes. A lower CCC value usually indicates that the business is efficient in managing its operations and vice versa.

3. Managing Existing Credit Facilities

The use of borrowed capital helps a business grow and be profitable because it gives it the ability to manage short-term and long-term needs such as bolstering its cash reserves for future net working capital requirements and capital expenditure investments.

A business must not only build a strong rapport with its lenders but also regularly monitor all of its existing credit facilities to ensure full covenants compliance, match facilities to the purpose of the loan, manage debt maturities and obtain the best financing rates.

The Importance of Measuring and Managing Liquidity Risk

If business leaders don’t thoroughly understand liquidity risk sources and the principles of measuring and managing liquidity risk, insolvency risk skyrockets. Today’s unprecedented challenges have certainly underscored this. Any business with liquidity concerns should consider bringing in an experienced, objective consultant for a thorough liquidity risk evaluation before trouble escalates. An expert can help to get you back on course and provide a plan for keeping you there.

The COVID-19 pandemic has made liquidity a pressing issue for many businesses. If you need help measuring and managing liquidity risk, reach out to 8020 before a downward spiral has begun. You can also learn more about our cash flow forecasting services by downloading the resource below.

About the Author

Prior to joining 8020 Consulting, Joe was an Investment Banker with experience in capital and debt markets, M&A, IPO, credit, distressed assets, and financial assurance. His key responsibilities include buy-side and sell-side M&A, subsidiary spin-offs, capital raising through the debt and equity markets, structuring of hybrid securities, turnaround and restructuring , and due diligence support. Over the years, Joe has advised and raised capital for REITs, property developers, and major palm oil players. Joe has also lived and worked in a few of the world’s major financial cities such as Los Angeles, London, Singapore, and Hong Kong. Joe graduated from the University of Southern California, and he is a Chartered Accountant with the Institute of Chartered Accountants in England and Wales. Joe also holds the following FINRA licenses: Series 24, Series 63 and Series 79.

Join our mailing list.

Join our mailing list for exclusive content. No spam, just great insight.

Please share your location to continue.

Check our help guide for more info.