Liquidity risk

Liquidity risk: 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 part of the risk disclosures requirements under IFRS 7 Financial Instruments: Disclosures.

Management should disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the end of the reporting period [IFRS 7 31]. The disclosures require focus on the risks that arise from financial instruments and how they have been managed. These risks typically include, but are not limited to, credit risk, liquidity risk and market risk [IFRS 7 32].

Qualitative and quantitative disclosures are required. Management should therefore disclose, for each type of risk arising from financial instruments:

  • The exposures to risk and how they arise, and its objectives, policies and processes for managing the risk and the methods used to measure the risk (qualitative disclosure) [IFRS 7 33]; and Market risk
  • Summary quantitative data about its exposure to that risk at the end of the reporting period (quantitative disclosures) [IFRS 7 34]. Market risk

If the quantitative data disclosed at the end of the reporting period is unrepresentative of an entity’s exposure to risk during the period, management should provide further information that is representative [IFRS 7 35].

 

Liquidity risk maturity analysis

Management should disclose a maturity analysis for all non-derivative financial liabilities (including issued financial guarantee contracts) that shows the remaining contractual maturities [IFRS 7 para 39(a)]. The maturity analysis required for derivative financial liabilities should include the remaining contractual maturities for those derivative financial liabilities for which contractual maturities are essential for an understanding of the timing of the cash flows. [IFRS 7 39(b), IFRS 7 B11]

Something else -   Management of credit risk for financial instruments

Example – Fixed rate instrument

Company A has a R1 million loan from Bank A. The loan has the following terms:

  • fixed interest bearing loan @ 15% per annum
  • interest is calculated cumulatively
  • the loan is expected to be paid in 5 equal capital instalments

Cash flows in respect of the loan are as follows:

Period Interest Workings Cash flow in(out)
Cash inflow at inception R1,000,000
1 15% 1,000,000 * 15% = 150,000 interest plus 200,000 principal repayment (R350,000)
2 15% 800,000 * 15% = 120,000 interest plus 200,000 principal repayment (R320,000)
3 15% 600,000 * 18.5% = 111,000 interest plus 200,000 principal repayment (R311,000)
4 15% 400,000 * 18.5% = 74,000 interest plus 200,000 principal repayment (R274,000)
5 15% 200,000 * 18.5% = 37,000 interest plus 200,000 principal repayment (R237,000)
R ‘000 < 6 months 6 – 12 months 1 – 2 years 2 – 5 years Total
Fixed rate loan liability (350) (320) (822) (1,492)
Calculation No cash flows Period 1 R350 Period 2 R320 R311 + R274 + R237 Total interest plus principal

Example – Floating rate instrumentYield curve

Company A has a R1 million loan from Bank A. The loan has the following terms:

  • prime linked interest rate
  • the loan is redeemable in a bullet payment in 5 years time

Note: Interest is calculated using a risk adjusted forward curve (or a yield curve, see picture)

Cash flows in respect of the loan are as follows:

 

 

 

 

 

Period Interest Workings Cash flow in(out)
Cash inflow at inception R1,000,000
1 5.0% 1,000,000 * 5.0% = 50,000 interest (R50,000)
2 5.5% 1,000,000 * 5.5% = 55,000 interest (R55,000)
3 6.0% 1,000,000 * 6.0% = 60,000 interest (R60,000)
4 6.5% 1,000,000 * 6.5% = 65,000 interest (R65,000)
5 7.0% 1,000,000 * 7.0% = 70,000 interest plus 1,000,000 principal repayment (R1,070,000)
Something else -   Indicators of a possible default
R ‘000 < 6 months 6 – 12 months 1 – 2 years 2 – 5 years Total
Floating rate loan liability (50) (55) (1,195) (1,300)
Calculation No cash flows Period 1 R50 Period 2 R55 R60 + R65 + R1,070 Total interest plus principal

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.

Sufficient resources

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

Something else -   Identify the performance obligations in the contract

Current ration = current assets / current liabilities

Liquidity risk Liquidity risk Liquidity risk Liquidity risk

 

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.

 

General model of measurement of insurance contracts

 

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Something else -   Control and continuing involvement

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