From a company’s point of view Liquidity Risk is a risk that the company does not have enough liquid money to meet short term financial needs for day to day operations of the organization. Liquidity risk is the risk that an investment can’t be bought or sold quickly in the market to prevent losses. When there is a global market crisis (occurrence of catastrophic events or in emergency) market become highly illiquid.
It occurs when investors don’t have enough liquid money to meet their debt obligations , or when there are less or inefficient buyers, due to which the investors are not able to convert their assets or holdings into cash (liquid money ) without the possibility of losses (loss in capital and/or income ). The investor has to sell it’s assets at a loss when the market is down i.e. when there are less buyers in the market.
In companies the liquidity risk of that company is measured by investors by taking into account it’s short term liabilities and liquid assets , if it is seen that the company has a lot of liquidity risk then methods are deployed to lessen the gap between the available assets and liquidity reserves of the company .Methods like immediate selling of assets are deployed to generate enough liquidity for meeting the debt obligations of the company.
In financial institutions such as banks, RBI has given some guidelines related to maintain a stable ratio of assets and liquid cash reserves to be maintained at all times.
Liquidity risk can be avoided by diversification of investments, investing in long/short term securities based on liquidity needs in near and far future i.e. managing the time horizon of investments,and minimizing the debt of the institution/company if there is a possibility of a catastrophic event in the future.
How can an investor calculate Liquidity risk while buying shares of a company?
Current Ratio : It is the ratio of Current Assets to Current Liabilities. This ratio measures the company’s ability to pay short term obligations. The word “current assets” refers to those assets which can be converted into cash immediately in the near future.
Acid Test Ratio (Quick Ratio) : This is similar to current ratio with the only difference in cash being subtracted from current assets.
Quick ratio = (Current assets – Cash & Cash equivalents) / Current liabilities.