What is Liquidity Risk?

Whether you are buying a house or investing in financial products, liquidity is one of the most important factors to consider. A lack of liquidity, also known as liquidity risk, can make any investment less attractive. This article will define liquidity risk, explain its types and importance, and offer practical tips to manage it effectively.  

Introduction To Liquidity Risk

Liquidity refers to the ease with which an asset can be converted into cash without significantly affecting its market value. Liquidity risk arises when an asset has limited buyers and, as a result, cannot be sold quickly without accepting a substantial discount, especially when immediate cash is required. 

Let’s understand this with the help of an example. 

Suppose you own a house worth ₹1 crore and a gold coin worth ₹5 lakh. Now you urgently need ₹1 lakh. When you try to sell both assets, you are more likely to find a buyer for the gold coin quickly and at a fair price. In contrast, selling a property may take longer, and you may also have to offer a steep discount. Hence, liquidity risk is higher for real estate compared to easily tradable assets, such as gold.  

Types Of Liquidity Risk

Liquidity risk can be broadly classified into two types:

1. Funding Liquidity Risk

This type of liquidity risk arises when an individual or business is unable to access enough cash to meet immediate obligations, despite having substantial assets on paper. 

Businesses typically rely on operating cash flows to manage short-term liabilities. Failing to make timely payments can damage reputation, cause share prices to fall, and make it harder to raise capital in the future. 

To assess a company’s funding liquidity risk, investors can use the following metrics:

• Current ratio: This is the ratio of a company’s current assets to current liabilities. It essentially demonstrates their ability to repay short-term debt without liquidating capital assets.

Current ratio: Current assets/Current liabilities 

• Quick ratio: While the current ratio includes all current assets, the quick ratio measures the liquid assets the company has to pay current liabilities. 

Quick ratio: Cash + cash equivalents/Current liabilities 

• Interest coverage ratio: This metric highlights the company’s ability to meet its interest obligations on outstanding loans using its Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). 

Interest coverage ratio: EBITDA/total interest expense

Example

Aditya is a small business owner with business equipment worth ₹20 lakh and a bank balance of ₹3 lakh. He urgently needs ₹5 lakh to cover operational costs. Despite having assets on paper, Aditya is unable to meet his immediate obligations due to a lack of liquid cash. Selling his equipment could take time and might not be a sound business move. To meet his short-term needs, Aditya resorts to debt, inviting additional interest costs and financial pressure.

2. Market Liquidity Risk

Market liquidity risk arises when a security cannot be sold easily at its fair market value. This often happens due to poor market demand caused by several factors, such as company-specific events and global crises.

When stock prices plummet, buyers panic and rush to sell. The increased supply and reduced demand lead to steep price drops. Generally, market liquidity risk is higher in small and mid-cap stocks. 

The most common method for measuring market liquidity is the bid-ask spread. It is the difference between the ask price—the price at which sellers want to sell—and the bid price—the price at which buyers want to purchase. A large bid-ask spread indicates a strong disagreement on price between buyers and sellers, leading to lower trading volumes. 

Bid-ask-spread= Ask price - Bid price 

Example

Roy holds 500 shares of a small-cap company, each valued at ₹20, making his total investment ₹10,000. As the market falls, investor confidence weakens, and the number of available buyers reduces. When Roy tries to sell his shares, the best offer he gets is ₹10 per share. He is forced to accept ₹5,000 and endure a 50% loss. This loss is due to market illiquidity.  

Why Liquidity Risk Matters?

Understanding liquidity risks is crucial for both businesses and individuals, as it significantly impacts decision-making. 

Liquidity risk may force investors to sell their assets at a lower price, especially during market lows. This not only results in losses but can also affect long-term goals. In some cases, a lack of funds may prompt them to take on high-interest debt, potentially leading to a debt trap. Understanding liquidity risk is crucial in building a diversified portfolio that includes both liquid and illiquid assets, along with a well-maintained emergency fund. 

For businesses, cash is the lifeline. Liquidity risk can disrupt business activities, cause losses, and may even lead to insolvency. The inability to meet obligations, such as making timely payments to vendors, can lead to a decline in credit score, which in turn affects borrowing capacity. Delayed payments to employees can hurt their morale and faith in the company’s management. Poor liquidity management may also deter investors from trusting the business. 

Additional Read: Credit Score vs. Credit Rating: Know the Difference

How To Manage Liquidity Risk?

Here are some practical tips to avoid the risk of market illiquidity: 

1. Keep a diversified investment portfolio: Ensure your portfolio has a mix of liquid and illiquid assets. For instance, if you have invested heavily in real estate, consider adding liquid investments such as stocks and mutual funds to create balance. It helps you manage cash needs without touching long-term assets.
2. Be emergency-ready: Create and maintain a strong emergency fund, sufficient to cover at least three to six months of living expenses without any income. This ensures you do not liquidate investments at the wrong time, and they stay aligned with your financial goals.
3. Know the exit rules and tax implications: Know the exit options of the investments you choose. For instance, certain mutual funds levy an exit load if you withdraw before a specified period. Although the percentage may seem small, it can cost a lot if the investment value is high. Also, check the process and time required to exit an investment. Consider tax implications on withdrawal, too. Some investments apply different tax rates based on the holding period. Withdrawing in the short term may attract higher taxes.
4. Stay updated about micro and macro-economic factors: Micro factors such as demand and supply, regulatory policies, and macro factors such as inflation and interest rate changes can all affect the liquidity of an investment. In times of financial turmoil, even liquid assets may become hard to sell. Staying informed enables better financial planning. 

Conclusion

Liquidity risk is an essential metric that supports smart decision-making. It helps you understand how readily assets can be converted into cash, preventing potential financial stress or losses.