Liquidity risk is the potential that an entity will be unable to acquire the cash required to meet short or intermediate term obligations. In many cases, capital is locked up in assets that are difficult to convert to cash when it is required to pay current bills. The following are illustrative examples of liquidity risk.
Accounts ReceivableAn IT consulting firm relies on reasonably timely customer payments in order to meet quarterly cash needs. A dispute with a large customer results in a sudden decline in cash flows and the firm misses a payroll payment. This results in compliance issues, fines and a severe decline in reputation and employee satisfaction.
Bank DepositsGenerally speaking, banks don't have the cash that would be required if all customers were to withdraw their deposits all at once. If economic conditions cause a large number of withdrawals, banks may require a large amount of cash in a short period of time.
Lines of CreditIn addition to deposits, unused space in lines of credit can quickly drain the liquidity of banks.
Debt TermsA manufacturing company has a small reserve of cash and a large unused line of credit. The firm experiences a period of rapidly declining prices due to industry oversupply. They quickly run out of cash as their operating margins turn negative. The line of credit becomes unavailable due to their poor financial metrics. The firm starts to miss payments and suppliers stop supplying them with essential inputs. The business goes into a downward spiral and is quickly bankrupt.
Marketable SecuritiesAn investor purchases a low volume small cap stock. The investor suddenly requires cash due to a personal emergency but has trouble selling the stock due to the low volume. The investor must set the price surprisingly low before their order finally fills. This results in a loss. If the investor had owned a high volume stock it could have been sold instantly at a market price with a low bid-ask spread.
AssetsAn investor who has all of their net worth in real estate generates cash by selling properties on a regular basis at a profit and purchasing new ones. This works for the investor while the market is hot. When market conditions change, houses are difficult to sell and it takes over a year to complete a single sale. The investor is short on cash and must sell a few properties at exceptionally low prices to attract buyers in a down market.
This is the complete list of articles we have written about risks.
If you enjoyed this page, please consider bookmarking Simplicable.
© 2010-2023 Simplicable. All Rights Reserved. Reproduction of materials found on this site, in any form, without explicit permission is prohibited.
View credits & copyrights or citation information for this page.