Definition: The risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities that are settled by delivering cash or another financial asset.
Liquidity risk is the most fundamental financial risk that companies need to manage. Insufficient or no access to liquidity or cash at a required time and location can have disastrous results and put the company at risk of discontinuity.
Liquidity means having sufficient resources to meet all your company’s foreseen and unforeseen obligations. Profits don’t pay bills, but cash does. A distinction can be made between funding and market liquidity risk. Funding liquidity risk means the risk that the company does not have the ability to obtain (sufficient) funding to meet its cash obligations. Market liquidity risk is the risk that funding cannot be obtained due to market disruption, as has been faced during the financial crisis when bond markets were closed and companies could not raise funding.
No standard approach
Despite the increased attention to liquidity risk, there is no standard approach to liquidity risk management yet. We have gained experience with managing liquidity risk at numerous large organizations. Liquidity management techniques such as intercompany netting and cash pooling, zero balancing and notional cash pooling are often used to optimize access to liquidity and interest paid or received.
Measurement of Liquidity Risk
One of the prime measurement of liquidity risk is the application of current ratio. The current ratio is the value of current or short-term assets as per current liabilities. The ideal ratio is believed to be more than 1, which suggests the firm has the capacity to pay its current liabilities from its short-term assets or
Current ration = current assets / current liabilities
Sears Holding stock fell by 9.8% on the back of continuing losses and poor quarterly results. Sears balance doesn’t look too good either. Moneymorning has named Sears Holding as one of the five companies that may go bankrupt soon.
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