Liquidity risk: finding the right balance

Somewhere between reckless risk-taking and conservatism lies the balance so highly valued by finance departments – the happy medium that will deliver both stability and performance.

As interest rates flirt with record lows, let’s consider how to manage liquidity risk, taking some cues along the way from those masters of the balancing act: tightrope walkers.

What’s at stake

Liquidity risk is the risk that the company will not be able to meet its short-term liabilities (for lack of sufficient available cash). Unlike solvency risk, liquidity risk is about the short term: the company’s long term financial equilibrium is not at issue.

Three financial ratios are commonly used to assess a non-financial institution’s liquidity risk: current ratio (the general 12 months liquidity ratio), Quick ratio (aka Acid test ratio), and Cash ratio.

Unfortunately, many companies settle for maximising one or more of these metrics, without considering factors specific to their sector or the potential impacts of market events on their current and future sources of funds.

Looking for dynamic balance

The best companies target the dynamic balance demonstrated by tightrope walkers to reconcile the twin demands of stability and performance, rather than the static balance best illustrated by a stool.

Although liquidity risk is a short-term risk, companies must still look far ahead to accurately estimate net debt and forecast upcoming financing needs.

By planning ahead, you can avoid being taken by surprise by the impact of bank covenants and minimise finance costs, while ensuring your company stays within its short-, medium- and long-term liquidity ratios.

But with financial markets being as volatile as they are, even the most detailed and rigorous projections are still subject to a degree of uncertainty. Debt markets in particular can swing from calm to turbulent in the blink of an eye and quickly price in tighter lending conditions.

Stress tests are essential to anticipating the consequences of extreme scenarios and ensuring your company is robust enough to weather the storm or, better, “antifragile” enough to take advantage of adverse market conditions (to grasp an opportunity for an acquisition or gain the edge over a competitor, for example).

In a word, liquidity risk management isn’t something you engage in once in a while to secure static balance. It requires an ongoing effort to strike a dynamic balance, because your company’s performance depends on it.

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