Steering Clear of Trouble: Addressing Liquidity Risks through Effective Risk Management

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Companies face a number of business risks that can threaten their ability to achieve their goals if these risks are not effectively addressed and managed. Business risks include everything from financial and reputational risks to compliance and cybersecurity risks, all of which can have a significant influence on a company’s strategic plans if business leaders don’t take action to mitigate them.

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Liquid risk has been a hot topic for businesses of all sizes and industries. It refers to the potential for a company to experience difficulties in meeting its financial obligations as they come due.  Factors that can contribute to liquidity risk include a decline in sales or revenue, unexpected increases in expenses, or changes in the credit markets that make it more difficult to obtain funding.

One study conducted by the Federal Reserve found that small and medium-sized businesses are particularly vulnerable to liquidity risk, as they often have limited access to funding and may not have the resources to manage cash flow effectively.

Another study conducted by the International Monetary Fund found that liquidity risk is closely linked to a company’s funding structure and maturity mismatch between assets and liabilities. The study also found that companies with high leverage and low profitability are more vulnerable to liquidity risk.

The studies presented above have vividly highlighted the importance of liquidity risk management for businesses. A study by the International Monetary Fund (IMF) found that a lack of liquidity was a key factor in the spread of the 2008 global financial crisis. When a business experiences a lack of liquidity, it can lead to a number of negative consequences, including difficulty in obtaining new funding, defaulting on loans, or even bankruptcy. It can also negatively impact a company’s reputation and creditworthiness, resulting in the failure of the stability and sustainability of the business.

In today’s fast-paced business environment, where market conditions can change rapidly, having a solid liquidity risk management plan in place can be the difference between a company’s success or failure. In this article, we will discuss the causes of liquidity risk and the solution that businesses can implement to mitigate this risk. By understanding the causes of liquidity risk and the solution available, businesses can take steps to protect themselves from this risk and ensure the long-term success of their operations.

Sources of Liquidity Risk (https://8020consulting.com/principles-of-measuring-and-managing-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 a healthy and well-managed cash flow will face an uphill battle to remain profitable, secure favorable financing terms, attract potential investors 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 good relationships 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. Pandemic lockdown 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 profit 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.

 

The Role of Liquidity risk management (https://www.riskmethods.net/resilient-enterprise/liquidity-risk-everything-you-need-to-know)

As 2020 showed, in an economic shock, formerly profitable businesses can be suddenly strapped for cash. To protect your business from financial impacts arising from supplier liquidity risk, you need to identify, assess, and mitigate the threats. This is where the solution for liquidity risk can enter.

Liquidity risk management is the process of identifying, measuring, monitoring and controlling the potential risks associated with a company’s ability to meet its financial obligations as they come due. This includes assessing the availability of cash and other liquid assets to meet short-term obligations, as well as managing the risk that the value of assets may decline due to market conditions. It also involves maintaining adequate levels of capital and contingency funding plans to ensure that the company can continue to operate in the event of unexpected events such as a financial crisis.

Specifically, businesses can prevent liquidity risks by:

        Identifying potential liquidity risks among suppliers. Define and use key performance indicators for risk, for example, to track their solvency or any market changes that might affect prices.

        Assessing the impact of product shortfalls or supplier financial distress on the category and on production. Then monitor liquidity risks in real-time to be able to recognize negative patterns quickly.

        Mitigating any potential liquidity risk impact through stress tests (simulation and forecasting). Have contingency plans in place for handling negative scenarios.

        Using a comprehensive risk management solution that figures in the cost of risk. Lay the groundwork for dealing with unforeseen events. Then your suppliers, and you, can keep the cash flowing and continue to draw from the well.

Effective liquidity risk management is essential for a company to maintain its solvency and stability, and to avoid the risk of default on its financial obligations. If business leaders don’t thoroughly understand liquidity risk sources and the principles of measuring and managing liquidity risk, insolvency risk skyrockets, and today’s unprecedented challenges have certainly underscored this. If a business has any liquidity concerns it would be beneficial to bring in an experienced, objective consultant for a thorough liquidity risk evaluation.

 

HWAA’s expert solution for your business!

If your business is looking to avoid or mitigate liquidity risks, consider outsourcing this important task to a professional risk management firm such as HWA Alliance of CPA Firms, Inc. Our experienced team can help your business to identify potential liquidity issues and develop strategies to address them. We can assist you in maintaining adequate levels of cash and other liquid assets, establishing lines of credit or other funding sources, and regularly reviewing and forecasting financial needs. We also provide guidance on monitoring and managing debt levels, including short-term and long-term debt, to mitigate liquidity risk.

 

Don’t let liquidity risk threaten the stability and sustainability of your business. Contact HWAA today to learn more about how we can help you with risk management and to schedule a consultation.