Funding Liquidity Risk

Funding liquidity risk is the possibility that an individual or organization will be unable to raise adequate funds to meet current or future financial obligations. A mismatch between asset and liability maturities and liquidity causes this liquidity risk. It can impact both borrowers and creditors, as they may be exposed to rollover risk, refinancing risk, or withdrawal risk.

Rollover risk is the possibility that a borrower will not be able to extend or refinance a loan that is about to mature. The risk associated with refinancing is the possibility that a borrower might not be able to get more funding on suitable terms. The possibility that a lender will not be able to retrieve or withdraw their money from a borrower or market is known as withdrawal risk. There are several types of elements that might affect funding liquidity risk, including interest rate, credit rating, market projections, liquidity choices, and contagion impacts. 

The factors affecting this risk include the following:

• Ineffective cash flow management: A solid cash flow management system dramatically enhances an organization's ability to recognize its liquidity position and possible challenges. Without it, a company may struggle to maintain profitability, secure favorable financing terms, attract prospective inventors, and be long-term viable.
• Lack of financing: A company's liquidity risk is increased when it cannot secure financing or cannot do so on favorable terms and at competitive rates. Furthermore, having a history of missing payments or failing to fulfill contractual commitments on a loan could make it challenging to get financing. 
• Unplanned capital expenses: When an organization is substantially capital-intensive, like the transportation, telecommunications, or energy sectors, liquidity risk can rise in the absence of appropriate fixed asset management strategies. 
• Profit crisis: A company that is experiencing a profit crisis is often forced to start using its cash reserves. Long-term continuation of this will eventually exhaust cash reserves and result in a financial crisis for businesses.

This liquidity risk can be determined by examining liquidity ratios such as the quick and current ratios.

#1 - Current ratio: 

The current ratio shows an organization's current liabilities relative to its current assets. It helps to determine how well the organization can repay its debt.

Current Ratio (CR) = Current Assets/ Current Liabilities 

A high current ratio indicates that a business does not require selling up its capital assets in order to pay off its current short-term debts. On the other hand, a low ratio can serve as a warning sign for the organization's future success.

#2 - Quick ratio:

Investors commonly employ this ratio to manage liquidity risk and ensure that their capital has low-risk exposure.

Quick Ratio (QR) = (cash/ cash equivalents marketable securities net accounts receivable) / Current liabilities

The quick ratio takes into consideration all of a company's easily converted liquid assets, which can be used to pay off all of its current debts. A high quick ratio can sometimes be a sign of ineffective management, even while it also shows a company's robust financial base.

In order to mitigate this liquidity risk, businesses must keep monitoring their liquidity situation. It can be done in the following ways:

• The level of reliance on funding: Companies that rely heavily on funding are more vulnerable to this liquidity risk. As a result, it would be crucial to evaluate financing options and work to reduce unnecessary financing.
• Sales seasonality: Cyclical businesses may experience weak cash flows at particular periods. As a result, it would be crucial to evaluate cyclical phases with low cash flows and find strategies for reducing operating expenses during those times.
• The availability of funds: A traditional way to reduce this liquidity risk is to have a line of credit. A credit line is a predefined quantity of credit provided to a borrower. The individual who borrows is only charged interest on the amount withdrawn from the line of credit. A high cash availability would enable the business to fulfill its debt obligations.

Let us go through the following examples to understand this liquidity risk:

Example #1

Let us assume that Rose Cosmetics manufactures beauty and cosmetic products. In a particular period, the company’s current assets amounted to $450,000, and its current liabilities amounted to $150,000. To analyze the company’s liquidity risk, we can calculate its current ratio.

According to the current ratio formula,

Current Ratio (CR) = Current Assets / Current Liabilities 

= $450,000 / $150,000

= 3

Therefore, we can see that the company has a solid current ratio and is free from liquidity risk. This is a funding liquidity risk example.

Example #2

According to an International Monetary Fund assessment, regulators must maintain an increased focus on the rapidly expanding private loan market because of possible issues about risks associated with funding liquidity. The analysis was made public as a component of an IMF report on global financial stability. It describes the crucial function that the $1.7 trillion sector plays in the debt markets and highlights potential risks that are challenging to identify due to a lack of information and transparency. In order to more precisely assess risk, the IMF advised authorities to adopt a more proactive approach and demand more thorough disclosure from market participants. This is another funding liquidity risk example.