What is Liquidity Risk?

Liquidity refers to the ease with which an asset (equity shares, debentures, etc.) can be traded in the stock market in exchange for currency. Consequently, liquidity risk depicts the risks associated with such trades, as the successful conversion of stock into money depends on various parameters such as book value of a company, bid-ask spreads for shares in the market, etc.

Typically, high liquidity risk indicates that particular security cannot be readily bought or sold in the share market. This is because an issuing company might face challenges in meeting its current liabilities due to reduced cash flow.

Small and mid-scale companies (having a market cap below Rs. 5,000 crore and Rs. 20,000 crores respectively) are categorised as organisations having high liquidity risk.

Such high risks arise from the volatility of these companies, as they are heavily dependent on equity cash flows for a generation of revenue. Trading liquidity risk is also high in such situations, as the demand for the same fluctuates heavily as per prevailing market conditions.

Alternatively, large-cap companies having market capitalisation figures above Rs. 20,000 crores enjoy lower liquidity risk in the market, owing to its sturdy financial base and high demand, leading to higher trading volume.

Types of Liquidity Risk

Liquidity risk of an investment can be of two types –

Funding liquidity risk 

Such risks are associated with the intrinsic values of a company, as it indicates their ability to meet its short-term debt obligations through operating cash flows. Inability to meet its current liabilities (defaulting on loans) can lead to a poor market reputation of such organisations, which can cause a massive fall in their share prices, as investors lose faith regarding their credibility and future performance.

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Surging amounts of debt with reduced current assets might require a company to liquidate (sell) its current asset base to fulfil its obligations, affecting its future revenue earning capacity significantly.

Measures of Funding Liquidity – 

Individuals should measure the funding liquidity risk of companies before investing, so as to develop a thorough idea regarding the future performance and earnings through the following parameters –

Current ratio

Also known as the working capital ratio, the current ratio depicts the current liabilities of a company with respect to its current assets, thereby indicating its repayment capability.

Current Ratio (CR) = Current Assets/ Current Liabilities 

A high CR implies that a company has enough revenue to pay off its existing short-term debts without having to liquidate its capital assets. A low CR, on the other hand, acts as a negative indicator regarding the future performance of respective companies.

However, it should be noted that extremely high values of CR represent a misallocation of resources with respect to production, causing a company to lose out on higher sales potential. Hence, having a current ratio equal to or slightly higher than the industry average is recommended.

Quick ratio

It is a popular ratio used by investors for ideal liquidity risk management to ensure minimal funding risk exposure of the corpus invested.

Quick Ratio (QR) = (cash/ cash equivalents marketable securities net accounts receivable) / Current liabilities

QR takes into account all liquid assets of a company, which can be easily converted to monetary terms to repay all current liabilities. While a high QR indicates a strong financial base of a company, it might also indicate inefficient management in some cases.

Interest coverage ratio 

The interest coverage ratio reflects the ability of a company to meet its interest obligations on outstanding loans (both short and long term) through its earnings before interest and taxes for a specified period of time.

Interest Coverage Ratio (ICR) = earnings (before interest and taxes) / total interest expense

The ICR indicates not only short term funding liquidity risk associated with a company but also its long-term solvency implications. A low ICR means that the total earnings of a business over a specified time go into meeting its interest liability only, leaving a small amount to repay the principal value on outstanding debts. Thus, in the event of bankruptcy, equity shareholders are unlikely to get back the entire funds invested, as the majority of liquidated capital asset value will go into repaying debts of the business.

An ICR below 1.5 represents high funding liquidity and solvency risks for a company, and hence, discourages investment.

  • Market liquidity risk

Such types of liquidity risks cater to the systematic risk component associated with market investments, accruing to the volatility of stock markets. Market forces play an important role in determining such trading liquidity risk, as corresponding fluctuations in share prices affect the trading patterns of respective securities listed on stock exchanges.

A high market liquidity risk indicates that selling stipulated securities might be challenging, accruing to low demand for the same. Such reduced demand can arise due to multiple reasons, such as –

  • Highly volatile stocks readily susceptible to price fluctuations
  • Ongoing economic crisis/ recession
  • A discredited reputation of a company due to certain events
  • Global economic scenario

During such times, the stock prices of a company often plummet, causing shareholders to panic. This is in tandem to falling demand, as individuals are uncertain about the future performance of the company. As a rush for sell orders on such securities are placed, with no corresponding buy orders, a low trade volume is observed as an adequate number of market participants are not present to facilitate the exchange of shares.

The price of respective shares is driven down further due to excess supply in a market. Individuals willing to exit their position in such conditions end up realising substantial losses on their investment.

Stocks of small and mid-cap companies have high market liquidity risk, as stated above. This is because buyers are uncertain of their potential growth in the future and hence, are unwilling to purchase such securities in fear of incurring losses in the long term. At the same time, a panic amongst existing shareholders is noticed in the face of a stock market downturn because such companies often lack the financial backing to recuperate from these downturns.

Many other forms of investment, such as real estate, also have high associated trading liquidity risk, as the process of purchase and sale of such assets involve a significant time lapse. Such time required for processing trade increases during times of high uncertainty in an economy.

Hence, before investing in any market security, analysing the trading liquidity risk is essential, as it gives an idea regarding the liquidation of such assets, and the capital gains or losses realised henceforth.

A measure of market liquidity risk – Bid-ask spread 

It is the most popular measure of systematic liquidity risk, derived by subtracting the ask price (quoted by sellers) from the bid price (quoted by buyers). A high bid-ask spread represents that sellers are asking for a higher price compared to what the buyers are willing to pay for a particular security. This mismatch in prices often reduces the trade volume of such securities in the market, indicating illiquidity. An individual willing to cash in their investments immediately will need to settle for the lower bid price, which might lead to capital losses or reduced expected capital gains.

The primary determinant of the bid-ask spread of security is its corresponding market demand and supply conditions. A higher bid-ask spread indicates high levels of exposure to market liquidity risk, as noticed in the case of small and mid-scale companies. Large-cap companies, on the other hand, enjoy lower systematic risk levels, as investor confidence in such shares is retained, irrespective of market fluctuations.

Investors consider funding liquidity risk as a crucial parameter while analysing the profitability of a business venture, as it depicts the potential for growth demonstrated by a company. Market liquidity risk, on the other hand, indicates the response of investors to any fluctuations in the stock prices, thereby acting as a measure of stock volatility.

While funding risks depend upon the governance and internal management of a company, international accords such as Basel Accord III act as the governing rule to keep the trading liquidity risk in stock markets in check on a macroeconomic level.