Liquidity Risk Definition and Quiz for Investment Modeling

Understanding the Facets of Liquidity Risk

Intermediate

Liquidity Risk reflects the potential for loss due to the speed at which an entity's asset can be liquidated, funding shortfalls covered, or a trading instrument can be sold to generate cash.

Synonyms: funding risk, trading risk

For context, think about three scenarios in which analysts, investors or counterparties would be concerned about liquidity risk.

Balance Sheet Liquidity
Funding Liquidity
Trading Liquidity

First, when evaluating a company's balance sheet liquidity it's important to note that assets and liabilities are sorted by their presumed liquidity. To illustrate, using GAAP standards, 'Cash & Equivalents' is typically ranked first, followed by 'Accounts Receivable' and 'Inventories'. These are all considered current assets. Assets such as 'Property, Plant & Equipment', which refers to buildings and equipment, plus 'Intangibles', which relate to assets that are difficult to value like customer lists, have less liquidity.

The liabilities side of the balance sheet is similar, with the nearest-term liabilities shown first for GAAP financials.

The current ratio and quick ratios are liquidity measures that help the analyst assess balance sheet liquidity risk.

Second, funding liquidity relates to the ability for an organization to tap internal and external sources of liquidity to cover unexpected declines in cash flow. Internal sources include items identified as 'Cash & Equivalents' or 'Marketable Securities'. External sources of liquidity may include commercial paper or bank lines of credit.

Third, from the perspective of investments and portfolios, trading liquidity refers to how quickly an investor's position in an equity, fixed income or real estate instrument can be sold for cash, without negatively impacting the price of the asset. The vwap measure, or volume weighted average price, can be used to evaluate the size of the investor's position as it relates to how much volume trades on a daily basis. Large pension plans, insurance companies and mutual funds use this measure to assess a portfolio's liquidity risk.

In a Sentence

Jim: My client inherited 100,000 shares of Acme, and wants to sell. Should we put in an order to sell at 'market', which is currently $75?
Kay: If you want Acme to not see $75 again. This position represents 30 days of vwap Jim, and a significant liquidity risk.

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Quiz

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Companies with current assets that exceed current liabilities by a wide margin indicate lower liquidity risk. | True or False?

True

Many institutions maintain lines of credit with banks that they rarely draw from. These offer protections should unexpected funding needs arise. | True or False?

True

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Liquidity Risk Definition and Quiz