Liquidity risk

Liquidity risk - can occur if the company is not managing its current assets appropriately. This risk is very important because it is pointed at short term obligations that should be paid or fulfilled in short term period.

If the company has not enough funds to fulfill long term obligations at the moment, but it is healthy when looking at the short term period, there might be a possibility for it to get well and fix the problems inside. But if the company comes to a moment when it is not liquid enough to pay the most important current obligations immediately, it can face liquidity risk and go bankrupt.

To see the level of liquidity of the company usually liquidity ratios are used. Usually there are two types of ratios used to evaluate the level of liquid funds in the company. Current ratio is used to show how company is ready to fulfill obligations during one year time, and it includes inventory, that can be liquidated to fulfill these obligations. For more strict analysis quick ratio is used, when only the most liquid asset is taken into consideration. Quick ratio doesn’t include inventory, which cannot be very liquid.

If the company is facing liquidity risk, business for it is getting even worse, because inability to pay short term obligations decreases the respectability of the company and its credit rating decreases as well. It means that partners start avoid working with this company, because it cannot pay for materials, products or services. As a consequence to all problems - banks are not willing to lend for the company as well, because they see that the company will not be able to pay its monthly payments.

It is known widely that one risk influences another risks and if the company takes relatively high part of the market, its problems can lead to systemic risk. If the company is trading internationally, and there are high currency fluctuations or interest rates have changed considerably, such situation can cause market risk. It can also be caused by the changes of the value of current assets. If the company will become unable to pay its current payments it will cause credit risk.

It is also very important to mention that high-tech companies that are making high-tech products shouldn’t overestimate the amount of inventory which is planned to be sold. When technologies of the products are changing so quickly, the company can face a problem if it will keep a lot of low-tech products as inventory. If a competitor will find a new technique to make a product better with more and better facilities in it, the value of old inventory will decrease, and it will become illiquid, so the company can face liquidity risk immediately. To avoid this, the company should differentiate the production, follow latest technology, invest in research and development, and avoid overestimated inventory.

Liquidity risk is important because it can cause systemic risk and lead company to bankruptcy. Besides short term obligations and funds to pay them, it is also needed to check if the obligations and demand for liquid fund is not seasonable. If this happens - company should hold higher amounts of liquid assets during peak periods to fulfill its short term obligations and to avoid liquidity risk.