Managing liquidity risk is a top priority for finance managers all over the world. Since the 2008 economic crisis, financial institutions have been under pressure to keep hold of cash. But tight liquidity management applies to more than just the big banks.
In this article, we’re exploring the role liquidity risk plays in treasury and how to go about managing it.
What is liquidity risk?
Put simply, liquidity risk is a measure used by businesses to determine how likely they can meet their short-term debt obligations.
Often, businesses pay their debts using cash. If a business has insufficient cash – and is unable to convert its assets into cash easily – it risks becoming insolvent.
Insolvency occurs when a business’s liabilities exceed its total assets. It can cause serious damage and put businesses in danger of shutting down.
So, it’s crucial companies manage liquidity risk. And a major part of this is identifying the causes.
What causes liquidity risk?
Many factors can cause liquidity risk. In some cases, poor management is to blame. In others, unexpected economic events can catch treasurers off guard.
Poor cashflow management
Cash is king. And not having enough to hand can create big problems for treasurers. It’s therefore vital that the flow of cash in and out of a company is handled properly.
Well-managed cash flow provides businesses with clear visibility into the challenges and opportunities brought about by liquidity.
When cash flow is managed poorly, a business becomes vulnerable to liquidity risks.
For instance, let’s say a company’s inventory is poorly managed and becomes overstocked. It has too many products stuck on shelves, tying up capital and taking up costly warehouse space.
With no revenue coming in from sales of the product, and expenses going out to keep the product stored, the business starts to experience negative cash flow.
As the company’s cash depletes, it struggles to pay its short-term debts. The company, therefore, experiences liquidity risk.
Problems sourcing finance
Nearly all companies need to borrow money at some point. Whether it’s investing in new equipment, launching an advertising campaign or opening a new office, sourcing finance is essential for business growth. And not being able to do so can put a business face to face with liquidity risk.
To ensure they can get their hands on financing, businesses need to appeal to lenders. If they are slow to repay debts – or default on payments entirely – they could struggle to source financing in the future.
It is therefore imperative that companies practice maturity matching. This means matching the life expectancy of an asset with the length of a loan used to finance it.
They’ll also need to possess a good capital management structure and maintain strong relationships with lenders.
Businesses unable to source funding altogether – or struggle to receive it at a competitive rate on acceptable terms – may be more exposed to liquidity risk.
Unexpected economic events
Occasionally, economic events happen that treasurers can’t control. These are often referred to as black swan events.
Occurrences like the Russian-Ukraine conflict, the Covid-19 pandemic, and the financial crisis of 2008 were unexpected and increased liquidity risk. Let’s look at an example.
Only a handful of people predicted the Covid-19 pandemic. And the fallout caused unprecedented economic damages.
Worldwide lockdowns came into force, restricting normal business operations and strangling supply chains.
Many businesses suffered heavy reductions in sales. And with no money coming in, pressure mounted on companies to meet their short-term debt obligations.
The impact of such an event dramatically increased liquidity risk for businesses all over the world.
How to manage corporate liquidity risk
Ultimately, limiting a business’s exposure to risk is a top challenge for corporate treasurers. So, they must anticipate liquidity risk to prevent any damages.
To do this, they’ll need to focus on their company’s cash position. We’ve already mentioned that cash is king and key to meeting short-term debt payments.
It’s therefore crucial that treasurers assess their present – and future – cash flow positions daily. They can use a cash management solution targeted specifically at liquidity risk management.
The goal would be to anticipate the flow of cash in and out of their businesses. This would ensure they have a good amount of liquidity for unexpected situations.
With this safety buffer in place, a company will be confident it can meet its short-term debt obligations as and when they come.
Raising funds to boost cash position
To avoid being cash-light and at the mercy of liquidity risk, companies can consider selling shares of their stock to raise equity capital. If they’re not able to take on more debt, selling additional shares could be an option to improve their cash position.
On the other hand, raising funds through traditional bank funding, dipping into overdrafts or resorting to factoring or leasing could be used in the short term to increase a business’s liquidity ratios.
Similarly, a company could raise short-term funds by selling a portion of its fixed assets. Although extreme, giving up such assets would free up cash in a time of need.
Lastly, businesses could focus on shortening their cash conversion cycle. This means reducing the gap between the inflow and outflow of cash.
To do this, companies can request upfront payments or deposits from their customers or reduce their payment deadlines. They could also consider offering a small discount for early payment. For example, a business could knock 2% off a bill if it’s paid within seven days.
Another approach may be to keep credit terms for customers at 30 or fewer days. This, partnered with active chasing for payments, will ensure businesses get paid on time, boosting their inflow of cash and tackling liquidity risk.
Protect against risk
We mentioned earlier that minimising financial risk is a key aspect of a treasurer’s role. And this is especially true for businesses that make international payments.
If your business makes payments using different currencies, you’ll know that currency markets are constantly moving. Even the most seasoned analysts never know for sure where markets are going. So, your best bet is to mitigate the risk of movements before they happen.
At Privalgo, we specialise in foreign exchange and international payments. Our financial solutions help limit the risk of market volatility, keeping your money safe.
To find out more about what we can do for you, book a free chat with a Privalgo Foreign Exchange Specialist.Book a chat