Risk management should be an integral part of any well-rounded business plan, particularly when it comes to financial risks. One of the most important risks for many businesses to manage is the risk of losing liquidity, or the ability to make payments, trades and other expenditures using liquid assets (i.e. cash, securities, etc.). Liquidity risk can be defined as the danger that an asset or security will be unusable in the market when needed, thus leading to a financial loss or failure to be profitable. There are many different potential risks to a company’s liquidity, and although the specific risks that a business faces may largely depend on its industry, where it does business and many other factors, there are some generalities that can be made. In general, the following liquidity risks are the most common and most threatening throughout the modern business community.
Top Liquidity Risks Facing Businesses Today
The most common risks to businesses’ liquidity can be categorized into risks to market liquidity and risks to funding liquidity. When a business’ market liquidity is at risk, it means their assets are untradeable, or at least untradeable at a price that will be profitable for the organization within a given time frame. Funding liquidity, on the other hand, is the risk that liabilities cannot be met within a given time frame and set of parameters. These are the top five risks:
- Facing liabilities that cannot be met at a reasonable cost
- Inability to meet liabilities at their due date
- The creation of overt, unsellable liquid assets
- Unusable reserves due to the elongation of the Value at Risk calculations holding period
- Widening of the spread between bids and offers for liquid assets
Where These Liquidity Risks Come From
In order to achieve liquidity risk management, or prevent risks altogether, it is important to understand where they come from. The most basic cause of any liquidity risk is the market’s lack of interest in an asset at the time the holder of that asset attempts to sell or trade it, which is particularly common in low-volume markets and emerging markets. This is different from having a worthless asset, but it does mean that the asset is not profitable at a given time, and it may be worth less than the amount of capital that the asset-holder has invested into the asset. In some cases, it’s just a matter of waiting for shifts in the market environment or finding the right interested party to trade the asset to. In other cases, the enterprise that is facing liquidity risk must make changes within itself to improve its liquidity. Improving the business’ credit rating, increasing its cash flow or making other adjustments may increase the ability to borrow money from and/or trade with other institutions. Some risks, such as a general loss of liquidity throughout an entire market or industry, are subject to so many outside factors that there is little an organization can do but ride out the storm until their assets are sellable or tradable again.
Tiffany advises companies, both new and established, on everything from their business plans to how to most effectively cope with risk. She hopes the information she has provided here will reach a wide audience and help them understand the specifics of liquidity risks, so they can act accordingly.