Measuring and Managing Liquidity Risks Analysis Essay

MEASURING AND MANAGING LIQUIDITY RISKS
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Measuring and Managing Liquidity Risks
Liquidity risk refers to the uncertainty that a business suffers of not meeting its financial obligations in a timely manner. Businesses without proper cash flow management and sound liquidity risk management strategies have a high probability of facing liquidity crisis and may eventually become insolvent. In the banking and finance sector, liquidity and solvency are twins as they often occur at the same time. An illiquid institution is highly insolvent compared to a liquid one. Therefore, it is important for businesses to establish suitable ways to measure and manage their liquidity risks. Tighter risk management culminates into market illiquidity, which further enhances risk management.
Liquidity Risk Analysis and Management
The first step in measuring and managing liquidity risk is to identity all the sources of this type of risk. The several sources of the risk include lack of cash flow management, inability to secure financing, unprecedented economic disruption, unplanned capital expenditures, and profit crisis (Wirija, 2020). The liquidity of a company is measured by determining its liquidity ratio, which entails its ability to pay off its current assets. A business that cannot easily liquidity its assets and pay off its debts is more at risk of becoming insolvent. Besides, the use of correct liquidity risk management strategies reduces the market liquidity of a firm, which inturn increases its value in the market (Garleanue & Pedersen, 2007). Therefore, businesses should always assess their liquidity and ensure that they avert any ventures that puts them at risk. This assessment can only be undertaken by relying on the suitable liquidity risk measurement strategies.
Measuring Liquidity Risk
Measuring liquidity risk is one of the most crucial steps in managing the risk as it enables the company to identify the warning signs of the crisis. Other than identification of the signs, organizations should also be able to assess the magnitude of the risk and take appropriate action to avert the effects. Liquidity risk can be measured using several approaches:
Analysis of Financial Ratios
Financial ratios are effective at assessing a company’s capital structure and its current risk levels, mainly in terms of its debt level and risk of bankruptcy. As Reilly and Brown (2011) note, financial ratios do not only help measure an organization’s performance, but also helps in other processes, such as stock valuation, assignment of credit quality ratings on bonds, and prediction of insolvency of a business. The several types of financial ratios that an institution can use to measure its liquidity include the defensive interval ratio, the current liability ratio, the required current liabilities to total current liabilities ratio, the working capital to debt ratio, and the risky asset conversion ratio (Haque, 2020). While this approach is quicker and helps a company assess how quickly it can convert its inventories into cash, the main challenge is that the ratios may vary based on the variations in the accounting standards or evaluation ...