Liquidity risk refers to a company's ability to meet its short-term financial obligations, such as paying off debts or operational expenses, without affecting its overall financial stability.
Topics to Discuss:
Importance of Liquidity Risk
How to Measure Liquidity
Liquidity Management Best Practices
How Recessions affect Liquidity
Difference Between Liquidity and Profitability
Importance of Liquidity Risk
Assessing liquidity risk determines whether a company has sufficient cash on hand or generating enough cash (cash inflows) to covers its uses of cash (cash outflows).
If a company exhibits greater cash inflows vs cash outflows, the company is more likely to meets its current financial obligations and absorb a severe, yet plausible, event, making its a safer prospect to do business with.
Advantages of a Strong Liquidity Position:
Meeting obligations: A strong liquidity position ensures a company can meet its short term obligations, like salaries, rents, current maturities, and capital expenditures.
Resilience to shocks: Liquidity serves as a buffer during economic downturns or unbudgeted losses. When a company has cash readily available, it can navigate through challenging times without resorting to layoffs or liquidating assets.
Flexibility and growth 0pportunities: Companies with higher liquidity are better equipped to expand competitive position, such as technology, product differentiation, skilled personnel, and strategic partnerships.
Lower borrowing costs: A strong liquidity position indicates a borrower can easily meet financial obligations, reducing default risk. Lenders view this positively, often offering lower interest rates and better terms, as the borrower is seen as financially stable and less likely to miss payments.
Overall, a counterparty with strong liquidity assures lenders of its ability to meet short-term obligations, reducing the risk of default. This financial stability makes the counterparty more creditworthy, encouraging lenders to offer favorable terms, lower interest rates, and higher credit limits.
How to Measure Liquidity
Measuring liquidity involves analyzing a company’s financial health to determine its ability to meet short-term obligations. This process begins with spreading financial statements, which standardizes data from balance sheets and income statements for clearer comparison over time.
Common liquidity ratios include:
Current Ratio (Current Assets / Current Liabilities): This ratio measures a company's ability to cover amounts owed (commonly accounts payable and current maturities) over the next 12 months with items owned that can be easily converted to cash over the next 12 months (commonly cash, accounts receivable and inventory).
Quick Ratio (Cash + Marketable Securities + Accounts Receivable ) / Current Liabilities): Also known as the acid-test ratio, the quick ratio is a more stringent measure of liquidity as it excludes inventory from current assets.
Cash Ratio (Cash and Cash Equivalents / Current Liabilities): The cash ratio is the most conservative measure of liquidity, only considering the most liquid assets - cash and cash equivalents.
Cash Inflow vs. Cash Outflow Ratio: This ratio measures a company's ability to cover cash outflows, not just current liabilities. Line items from the balance sheets, cash flow statement, and accompany notes are gathered and placed in one of the two categories.
Cash Inflows: Cash, Cash Flow From Operations, Available Portion of Bank Lines
of Credit, and Expected Asset Sales.
Cash Outflows: Cash Flow From Operations (if negative), Capital Expenditures,
Financial Obligations (Current Portion of Long Term Debt & Leases), and
Expected Shareholder Distributions.
Companies with cash inflows that cover cash outflows, preferable multiple
times over, are more likely to meet financial obligations and demonstrate a
greater ability to absorb unbudgeted losses.
Liquidity Management Best Practices
Not all liquidity risk assessments include financial ratio analysis. A holistic approach to liquidity ensures that a company can meets its short term financial obligations and continue its operations without disruption.
Additional items to consider when evaluating a counterparty's liquidity position:
The debt maturity schedule outlines when a company's debt payments are due. The schedule is categorized by timeframes (less than 1 year, 1-5 years, and beyond 5 years) and details each debt type and maturity date.
This schedule is key in credit analysis as it provides insight into liquidity risk, refinance risk, and interest rate risk.
Liquidity Risk - This risk focuses on debt maturing within one year, also known as current maturities. Liquidity risk increases when these maturities are significant and the company has tight or uncertain cash flow or limited access to credit.
Refinance Risk - This is the risk a company faces when it must secure new financing for maturing long-term debt or renew a line of credit. Refinance risk rises if lending conditions tighten or if the company’s weak financial health makes it difficult to obtain favorable financing terms.
Interest Rate Risk - The schedule can reveal a company’s exposure to interest rate risk, particularly with variable-rate debt. If interest rates rise before the debt matures, the company may face higher refinancing costs, increasing its overall financial burden.
The quality of assets and maintaining adequate cash reserves is also important to consider, as not all assets are equal. Assets like buildings and machinery are likely to take longer to sell and convert to cash. If a company's assets are mostly fixed or long term, the company may appear more liquid than it really is, which can be misleading.
How Recessions Affect Liquidity
In the business world, few terms get mentioned as frequently as "inflation", "interest rates", and "recession". Rightfully so, as they are the pulse and heartbeat of an economy, touching almost every aspect of the financial landscape. Let's dive into the impacts of a recession.
Typically, recessions are marked by a decrease in consumer spending, rising unemployment, a drop in business investments, and reduced industrial production. The general recognition of a recession is two consecutive quarters of a decline in a country's real gross domestic product (GDP), which is the value of all goods a services a country produces.
An economy can show signs of a weakening before a recession officially begins and triggers of a recession are widely studied yet challenging to predict because of the number of potential causes.
Here are some common recession characteristics:
Inflation refers to the increase in the general level of prices for goods and services. When inflation rates are high, the purchasing power of money decreases.
A company's revenue comes from consumer spending. If prices increase too much or too soon, one or both could discourage spending, which could lead to stagnant or declining company revenues.
It is important to note that while inflation leads to higher prices, it is also a sign an economy is growing. In periods of economic growth, companies are hiring, consumers are spending, and that increased demand can lead to an increase in prices.
Annual inflation rate of about 2% is considered acceptable.
Higher interest rates mean borrowing becomes expensive. This tactic is used to slow economic activity and keep inflation in check. The implications of higher interest rates include:
Higher Costs of Borrowing: Higher interest rates mean that borrowers will have to pay increased interest expense. If a company is unable to reduce costs elsewhere or pass on the costs to the consumer then margins, cash flow, and liquidity will be negatively impacted.
Decreased Demand for Loans: As the cost of borrowing increases, businesses and individually may be discouraged from taking out loans. This could lead to a decrease in business activity, expansion, and consumer spending, which can slow economic growth.
In summary, higher interest rates and inflation typically tighten borrowing conditions and decrease consumer spending, as the increased cost of products and debts can discourage borrowing and slow economic activity.
Differences Between Liquidity and Profitability
Liquidity and profitability are two key financial concepts, each playing a role in the credit rating methodology.
As discussed, liquidity refers to a company’s ability to meet its short-term obligations as they come due. The higher the multiplier—indicating how many times over a company can cover its financial obligations within one year—the stronger its liquidity position. This enhances its ability to absorb a severe, yet plausible, unbudgeted loss.
Profitability, on the other hand, measures how effectively a company generates profit from its operations. It reflects the company’s ability to generate earnings relative to its costs over a specific period. Profitability is a key indicator of long-term sustainability, growth potential, and the ability to reinvest in the business or return profits to shareholders.
Key profitability ratios include:
Gross Marin Ratio (Gross Profit / Revenue)
Operation Margin Ratio, aka EBIT % (Operating Income / Revenue)
Net Profit Margin (Net Income / Revenue)
Higher profitability ratios indicate a more profitable company. However, what is considered "high" varies by industry benchmarking and economic conditions. This is the reason CreditKernel rating methodology is calibrated using industry specific financial ratios and benchmarks to determine if a company is underperforming, on par, or overperforming compared to industry peers.
In essence, while liquidity focuses on short-term financial health and the ability to convert assets into cash, profitability is concerned with the ability to generate earnings in the long run.
Final Thoughts
Liquidity analysis is crucial for credit ratings, as it offers insights into a company's ability to meet its obligations, maintain stable operations, and withstand market downturns. A company with cash inflows that consistently exceed cash outflows, especially by multiple times, reduces its risk of default.
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Frequently Asked Questions
What are the primary indicators of liquidity risk in a company?
Liquidity risk indicators include declining cash balances, increased short term debts, low liquidity ratios, and negative cash flow from operating activities.
How can companies mitigate liquidity risk?
Companies can maintain adequate cash reserves, diversity income sources, adjust payment terms, and have access to credit facilities or lines of credit as backups.
How does a recession affect liquidity?
During a recession, a company's liquidity is often strained as revenues and/or operating margins decline, making it harder to cover short-term obligations. Companies may struggle to maintain cash flow, which could lead to difficulties in paying bills, salaries, and servicing debt. Reduced access to credit can add further challenges as bank are aware of the declining market conditions.