How to mitigate liquidity risk?

Recent events, coupled with the interest rate volatility across the world have cause many a treasurer to ask: What is our current liquidity position? What are our primary and secondary sources of liquidity? What counterparty risks could affect our liquidity? What are our contingency funding plans in case of a liquidity shortfall?  

If a business fails to answer these questions, it can have significant consequences: increased borrowing costs, forced asset sales at a loss, default on debt, missed business opportunities, and, when worse comes to worst, insolvency or going bankrupt. To get a grip on how to mitigate liquidity risk, read on: 

Liquidity crunch is no fun for anyone. Struggling to pay your immediate liabilities will soon result in late fees and penalties, not to mention how it will damage your relationships with your suppliers and creditors. Defaulting on a debt can trigger covenants, that allow creditors to demand immediate repayment of outstanding debts.  

Manage liquidity risk poorly, and lenders will see you as riskier, which will limit your ability to grow. No wonder that CFOs keep setting liquidity risk management as the top for their treasury departments. 

"Without a clear understanding of your cash flow, it's like flying blind. Businesses need accurate visibility into their liquidity position at all times to avoid costly surprises." – Karl-Henrik Sundberg, Product Manager, Cash Forecasting 

Meet the experts 

I had the opportunity to sit down with Nomentia's experts, Karl-Henrik Sundberg and Jouni Kirjola, to discuss the importance of liquidity risk management. Arguing from their accrued experience, they made the critical role of risk mitigation as part of liquidity management evident. 

Karl-Henrik Sundberg

Karl-Henrik Sundberg is a Senior Product Manager for Cash Forecasting at Nomentia, with nearly a decade of experience at the company. He brings valuable expertise from his prior roles as Director of Group Cash Management and Back Office in a Corporate Treasury, as well as in cash management software. 

Jouni Kirjola

Jouni Kirjola is the Head of Solutions and Presales at Nomentia, bringing nearly 20 years of expertise to the role. Specializing in payments, cash forecasting, in-house banking, and reconciliation, his extensive experience and deep knowledge of financial solutions make him a key expert in delivering tailored solutions.

What is liquidity risk? 

First, a few definitions. When we talk about liquidity risk, we mean the risk of an entity not being able to meet its financial obligations as they come due or that it will incur significant costs in doing so. Think of a retail operator holding a large inventory when demand drops; they might struggle to offload it. Or a company with an asset portfolio consisting of several properties. If they ever needed to turn them into cash, it might not happen without significant discounts. Think Lehman Brothers in 2008. Or Evergrade in 2021. Ensuring sufficient resources to meet obligations and continue operations, even under stress is the cornerstone of liquidity risk mitigation. Being prepared and proactive will allow you to align liquidity strategies with broader business objectives, but you should also be mindful of the key characteristics of liquidity risk. 

"Addressing liquidity risk requires a proactive mindset. You can’t wait until you’re in a crunch; it’s about planning for worst-case scenarios before they become a reality." –  Jouni Kirjola, Head of Solutions & Presales

Types of liquidity risk 

• Funding liquidity risk: Funding liquidity risk arises when a company (or financial institution) cannot secure enough funding to meet its obligations. Imagine a business that relies heavily on short-term borrowing and experiences a sudden downturn in sales while the lenders are unwilling to extend credit.
• Market liquidity risk: Market liquidity risk refers to the risk of a company being unable to buy or sell assets quickly enough to prevent or minimize a loss, which stems from an insufficient market depth or activity. Think of a financial institution that holds hard-to-sell during market downturns. Being forced to liquidate these assets quickly in less liquid markets where there are fewer buyers or sellers is likely to lead to significant losses that put liquidity at risk.
• Operational liquidity risk: When the company is facing difficulties in meeting its day-to-day financial obligations because of poor cash flow management or lack of contingency planning, we’re talking about operational liquidity risk. Think about a company’s critical software system failing and delaying billing and collections, which then causes the company’s cash flow to falter. 
• Contingent liquidity risk: Contingent liquidity risk refers to the potential need for liquidity that arises from specific events, like as a sudden spike in demand for cash. Another root cause for contingent liquidity risk could be unforeseen financial commitments. Think of a sudden change in regulatory requirements that forces institutions to hold more liquid assets than anticipated, causing a scramble for liquidity.
• Systemic liquidity risk: Systemic liquidity risk occurs at the market level and can affect multiple institutions or the entire financial system, often due to interconnectedness and contagion effects. As an example, imagine how during the financial crisis, many institutions faced systemic liquidity risk as the interbank lending market froze and made it impossible for even sound banks to obtain necessary funding. 

Liquidity risk: Knowns and unknowns 

Because liquidity risk mitigation is about ensuring your business has enough readily accessible funding, even under unforeseen duress, it’s best to come to terms with a certain level of uncertainty when it comes to markets and business. 

The concept of known knowns, known unknowns, unknown knowns, and unknown unknowns can help frame how treasurers approach liquidity risk management. Let’s break them down real quick: 

1. Known knowns: Known knowns are the risks and factors that are well understood and that businesses are fully aware of. They are quantifiable and can be managed with existing tools and strategies.
   • In relation to liquidity risk, we’re talking about things like cash flow pattern predictability, regular customer payment schedules, and, of course, established credit terms with suppliers. The implication is that businesses should be able to effectively plan for these known liquidity risk factors, allocate resources accordingly, and implement cash flow management practices to mitigate liquidity risks. 
2. Known unknows: Known unknowns are the risks and uncertainties that are recognized but not fully understood. Organizations know that these risks exist but may lack detailed information about their potential impact or probability.
   • When it comes to liquidity risk management and mitigation the risk examples understandably include potential economic downturns or changes in market conditions that have an effect on cash flow. A business might know that its sales are heavily dependent on seasonal demand but cannot predict exactly how much revenue will decline during off-peak seasons.  
     
   
   
3. Unknown knowns: These are the risks that organizations may have knowledge of, but this knowledge is not widely recognized or communicated within the organization. In other words, there are insights that are available but not acted upon.
   • A liquidity risk-related example could be historical data that shows patterns in accounts receivable collection but is not being utilized for forecasting future cash flow. Perhaps the finance team has insights into certain customers' payment behaviors, but this information hasn’t been systematically integrated into cash flow management strategies.  
4. Unknown unknowns: Unknown unknown are the risks and uncertainties that organizations are completely unaware of. These are unforeseen events or situations that cannot be predicted and can lead to significant consequences.
   • In relation to liquidity risk, we’re talking unexpected market crashes, sudden regulatory changes, or natural disasters. For instance, a business might not foresee a sudden global supply chain disruption due to a natural disaster, which then leads to cash flow challenges as it struggles to meet customer demand. 

"One of the biggest mistakes companies make is underestimating the importance of cash flow forecasting. An accurate forecast can be the difference between stability and crisis." – Karl-Henrik Sundberg, Product Manager, Cash Forecasting  

Is your liquidity at risk? 

Whether you’re trying to identify risk related to potential funding resources, prepare for unanticipated cash flow gaps, or detect signs of deteriorating working capital or credit risk, it all hinges on one thing: visibility. Answering questions like “Are there upcoming debt maturities or large payments that could strain liquidity?" "Are we seeing longer payment cycles or delays from customers?” or “Do we have sufficient liquidity buffers or contingency plans in place for stress scenarios?” is nigh impossible if you don't know what you should be looking for. Perhaps consider the following: 

1. Current Ratio: Current ratio is key metric to monitor when ensuring there’s enough of cash cushion to meet short-term obligations. A low current ratio may indicate emerging liquidity risks and difficulties in covering short-term liabilities.
   • Formula: Current Assets / Current Liabilities. 
2. Quick Ratio: Quick Ratio is a stricter liquidity measure that excludes inventory from current assets, giving a more conservative view of liquidity. It highlights liquidity without relying on potentially hard-to-sell inventory.
   • Formula: (Cash and cash equivalents + marketable securities + accounts receivable) / Current liabilities. 
3. Cash ratio: Cash ratio measures the company’s ability to pay off immediate liabilities using only cash and cash equivalents. Good one to check in a crisis.
   • Formula: Cash and Cash Equivalents / Current Liabilities. 
4. Operating Cash Flow Ratio: These ratios show how well-operating cash flow covers current liabilities. Tracking cash flow ratios help to assess the sustainability of cash generation.
   • Formula: Operating Cash Flow / Current Liabilities.
5. Days Sales Outstanding: DSO measures the average number of days it takes to collect payment after a sale. A rising DSO indicates slower collections and could point to potential cash flow issues. DSO is critical metric to spot delays in receivables and improve the efficiency of cash collection.
   • Formula: (Accounts Receivable / Total Credit Sales) × Number of Days.
6. Days Payable Outstanding (DPO): Days Payable Outstanding, or DPO, measures the average number of days the company takes to pay suppliers. Treasurers track DPO to balance liquidity management without straining supplier terms. 
   • Formula: (Accounts Payable / Cost of Goods Sold) × 365.  
7. Inventory Turnover Ratio: Inventory Turnover Rate indicates how quickly inventory is sold and replaced. As low turnover may indicate excess inventory, which is tying up cash treasurers use this metric to ensure that inventory is managed efficiently to free up cash. 
   • Formula: Cost of Goods Sold / Average Inventory.
8. Net Working Capital: NWC measures the difference between current assets and current liabilities. Use: Treasurers monitor NWC as a key indicator of short-term liquidity health. Positive NWC indicates liquidity to meet short-term obligations, while negative NWC is a red flag.
   • Formula: Current Assets - Current Liabilities. 
9. Debt-to-Equity Ratio: Compares total debt to shareholders’ equity. High debt relative to equity signals potential liquidity stress due to high leverage.
   • Formula: Total Liabilities / Shareholders’ Equity. 

How to assess and mitigate liquidity risk? 

In brief, the process of assessing and mitigating liquidity risk is simple enough: 

1. Identify the sources and root causes of liquidity risk: Start with risk identification from their root causes. 
2. Measure liquidity ratios: Utilizing metrics like current ratio and quick ratio helps to evaluate your risk level. 
3. Analyze potential liquidity gaps: Comparing cash inflows and cash outflows over differing time periods helps to identify gaps in liquidity. 
4. Run stress tests: Simulating unfavorable financial scenarios creates visibility into the impact on liquidity. 

"Collaboration across departments is key to managing liquidity risk. Siloed information can lead to gaps in your forecasts and ultimately compromise your liquidity position." – Jouni Kirjola 

Liquidity risk mitigation strategies 

"Cash visibility isn’t just about knowing what’s in the bank today; it’s about anticipating the future. Forecasting is critical because it allows you to stay ahead of potential liquidity risks." – Karl-Henrik 

1. Best practices for managing liquidity risk
   • Regular cash flow forecasting: Implementing a robust cash flow forecasting process helps to anticipate cash inflows and outflows and to identify potential liquidity shortfalls before they occur. 
   • Establishing a liquidity management policy: Companies would do well to create a formal policy that outlines how they will manage liquidity risk. The liquidity management policy should cover their target liquidity levels, acceptable liquidity ratios, and specific actions to be taken in case of a liquidity crisis. 
   • Monitoring market conditions: Staying updated on economic trends, regulatory changes, and market volatility helps businesses anticipate changes that may affect liquidity.
2. Improving cash flow management
   • Streamlining accounts receivable management: Businesses should implement strategies to expedite receivables, starting with automating invoicing and integrating financial systems to improve cash visibility. 
   • Inventory management: Optimizing inventory levels helps to avoid overstocking and reduces carrying costs.  
   • Payment terms negotiation: Negotiating more favorable payment terms with suppliers to extend payables without incurring penalties is likely to help improve cash flow during lean periods. 
   • Regular financial reviews: Conducting periodic reviews of financial performance helps identify areas of inefficiency in cash management. 
3. The role of liquidity reserves in mitigating risk 
   • Emergency funds: Maintaining liquidity reserves serves as a financial buffer against unexpected cash flow shortages.  
   • Confidence in business operations: Having adequate liquidity reserves enhances a company's ability to operate smoothly, even in challenging circumstances. 
   • Flexibility in investment decisions: Liquidity reserves provide the flexibility to capitalize on immediate investment opportunities or address unforeseen expenses without needing to secure additional financing. 
4. How diversification of funding sources helps
   • Reduced dependency on single sources: By diversifying funding sources (bank loans, credit lines, equity financing), businesses can reduce reliance on any single source. 
   • Increased resilience: A diverse funding strategy allows businesses to tap into different financial markets and instruments, which can be particularly advantageous during economic downturns or when certain sectors face challenges. 
   • Access to more favorable terms: Exploring multiple funding options can help businesses find more favorable interest rates and terms. 
   • Improved Financial Planning: With various funding options available, businesses can better plan for long-term financial stability and reduce the pressure to quickly secure financing during emergencies. 

Getting the best of liquidity risk challenges 

Active liquidity planning, proactive liquidity management, and accurate cash flow forecasting are essential tools for organizations to effectively navigate liquidity risks. Here's how each of these strategies can enhance visibility into unforeseen liquidity risks, address unknown knowns, and improve the management of knowns and unknowns: 

1. Active liquidity planning: Active liquidity planning requires the company to continuously assess its liquidity needs and develop strategies to ensure sufficient cash flow. This can include establishing liquidity targets, identifying potential funding sources, and preparing for various scenarios. Benefits of active liquidity planning include: 
   • Making unforeseen liquidity risks more visible: By engaging in active liquidity planning, businesses can simulate different financial scenarios to identify potential liquidity gaps and prepare for unexpected situations.
   • Addressing Unknown Knowns: Active liquidity planning involves gathering and analyzing historical data and financial information to uncover overlooked details to inform liquidity strategy. 
   • Improving management of Knowns and Unknowns: By continuously monitoring liquidity positions and market conditions, businesses can quickly respond to changes and make necessary adjustments.
2. Proactive liquidity management: Proactive liquidity management focuses on anticipating liquidity needs and implementing strategies to ensure that cash flow remains steady and predictable; monitoring cash positions, optimizing working capital, and securing lines of credit or other financing options in advance. Benefits of proactive liquidity management include:
   • Making unforeseen liquidity risks more visible: Proactive management includes regularly assessing the organization’s liquidity risk exposure and establishing early warning indicators. 
   • Addressing Unknown Knowns: By fostering a culture of proactive decision-making, businesses can encourage teams to share insights about cash flow patterns, customer payment behaviors, and vendor relationships. This collective awareness can reveal hidden knowledge that can be leveraged to improve liquidity management. 
   • Improving management of Knowns and Unknowns: Proactive strategies enable organizations to anticipate changes in cash flow and adjust their operations accordingly, which helps to minimize disruptions from both known and unknown risks.  Accurate cash flow forecasting
3. Accurate cash flow forecasting involves predicting future cash inflows and outflows based on historical data, current trends, and business plans. Cash forecasting should be done regularly and adjusted based on up-to-dare data and insights. Benefits of accurate cash flow forecasting include: 
   • Making Unforeseen liquidity risks more visible: Regularly updated cash flow forecasts will end up highlighting potential cash shortages well in advance, which allows businesses to plan for contingencies. 
   • Addressing Unknown Knowns: By analyzing cash flow forecasts alongside historical performance, organizations can identify patterns and trends that may have been overlooked. This can bring to light information that hasn’t been utilized effectively. 
   • Improving management of Knowns and Unknowns: Accurate forecasting provides a clearer picture of expected cash flow, allowing organizations to better manage their liquidity against known obligations and make informed decisions regarding future investments or expenditures, thus reducing uncertainty. 

"When you have a clear, data-driven view of your liquidity, you empower your business to make smarter, faster decisions in the face of uncertainty." – Jouni Kirjola 

From forecasting to action: Proactive liquidity risk control 

There’s no question that mitigating liquidity risk requires a comprehensive and proactive approach. Active liquidity planning, proactive liquidity management, and accurate cash flow forecasting form a solid foundation for managing both anticipated and unforeseen challenges. By utilizing scenario analysis, early warning indicators, and data-driven forecasting, businesses can gain deeper insights into their liquidity needs, collaborate effectively across departments, and respond swiftly to emerging risks – well-prepared for whatever uncertainties may arise.