What are the main steps to manage liquidation risk in corporate finance?

Liquidation risk is the possibility that a company cannot meet its short-term obligations and has to sell its assets at a loss or go bankrupt. This can have serious consequences for the company's reputation, operations, and stakeholders. Therefore, managing liquidation risk is a vital part of corporate finance. In this article, you will learn the main steps to manage liquidation risk in corporate finance and how to apply them in practice.

1 Identify the sources of liquidation risk

In order to manage liquidation risk, the first step is to identify the sources of liquidation risk for your company. This could include a mismatch between the maturity and liquidity of assets and liabilities, exposure to market fluctuations and shocks, dependence on external financing and credit conditions, or operational inefficiencies and risks. By recognizing these sources, you can estimate the magnitude and probability of the risk, as well as prioritize the areas that require attention.

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Wesam Alayyad

Seasoned Finance Strategist Accelerating Growth and Profit | 12+ Years of Experience in Promoting Value Creation with Excellence | CMA | FMVA | CSP | CKPIP | CPMP | Member of The FP&A Advisory Council
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To manage liquidation risk effectively, assess these top factors: 1. Regular financial analysis and monitoring 2. Effective cash flow management and forecasting 3. Balanced debt management and covenant compliance 4. Optimized working capital management 5. Regular assessment of asset value and contingency planning I also found it helpful to negotiate with suppliers for extended credit terms and implement a loyalty program, which can help mitigate risk.

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CA Tanushri Sharma

Content Creator • LinkedIn 21k • Instagram 7k
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Liquidity risk is when an organisation can't meet its short term obligations on time whether or not it has assets to cover them. Even if the organisation has assets, the assets may not be convertible to cash to pay off the liabilities. One needs to identify the indicators/ sources of Liquidity Risk before analysing it. Indications of Liquidity Risk could be - Mismatch between maturity of assets & liability - Exposure to Market Fluctuations - Dependency on external financing - Operational Inefficiencies - Major Debtor going bankrupt - Loss of a significant contract After recognising the source of risk one can - Anticipate the probability & magnitude of risk - Prioritise areas that require attention - Make strategies to reduce the risk

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2 Monitor the liquidity indicators

The second step to manage liquidation risk is to monitor the liquidity indicators for your company. These metrics measure your company's ability to meet its short-term obligations and generate cash flow. Common indicators include the current ratio, which is the ratio of current assets to current liabilities and shows how many times your company can cover its short-term debts with its short-term assets. A ratio above 1 indicates sufficient liquidity, and a ratio below 1 indicates potential liquidity problems. Additionally, there is the quick ratio, which is the ratio of quick assets to current liabilities and shows how many times your company can cover its short-term debts with its most liquid assets. A quick ratio above 1 indicates a strong liquidity position, while a quick ratio below 1 suggests difficulty in paying debts quickly. Lastly, there is the cash conversion cycle, which is the number of days it takes for your company to convert its inventory and receivables into cash and pay its payables. A shorter cash conversion cycle means faster cash flow, while a longer cycle indicates slower cash flow and may require more working capital. By monitoring these indicators, you can track your company's liquidity performance and identify any potential gaps or issues.

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CA Tanushri Sharma

Content Creator • LinkedIn 21k • Instagram 7k
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Monitoring Liquidity Indicators can help in managing Liquidity Risk. Some of the Indicators: (1) Current Ratio = Current Assets / Current Liabilities (2) Quick Ratio = (Current Assets- Inventory) / Current Liabilities Both ratios show how many times the company can cover its short term debts with short term assets. A ratio greater than 1 is considered favourable. (3) Debtor days = Average Debtors/ Revenue per day It shows the no. of days the company takes to recover its receivables. Cash conversion cycle indicates the no. of days in which the company can convert its inventory & receivables to pay its payables. A shorter cash conversation cycle is considered favourable as it shows faster cash flow & good working capital management

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3 Implement the liquidity strategies

The third step to manage liquidation risk is to implement the liquidity strategies for your company. These are actions that you can take to improve your company's liquidity position and reduce its liquidation risk. For example, you can increase cash inflows by increasing sales, improving pricing, offering discounts, collecting receivables faster, or selling excess or obsolete inventory. You can also decrease cash outflows by reducing costs, negotiating better terms with suppliers, delaying payments, or refinancing or restructuring debt. Additionally, you can maintain a cash buffer by keeping a sufficient amount of cash or cash equivalents on hand, or securing a line of credit or a revolving facility from a bank or lender. Lastly, you can diversify your funding sources by accessing different types of financing such as equity, debt, trade credit, or leasing. By implementing these strategies, you can enhance your company's liquidity position and mitigate its liquidation risk.

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4 Review and adjust the liquidity plan

The fourth step to manage liquidation risk is to review and adjust the liquidity plan for your company. This involves evaluating the effectiveness and suitability of your liquidity plan and making any necessary changes or improvements. When doing so, you should consider changes in the internal and external environment, such as those in your company's operations, performance, goals, and strategies, as well as market conditions, customer preferences, competitor actions, and regulatory requirements. Additionally, you should solicit feedback from stakeholders who are involved or affected by your liquidity plan. Performance against benchmarks should also be measured and compared to assess your liquidity strengths and weaknesses. By reviewing and adjusting your liquidity plan accordingly, you can ensure that it is relevant, realistic, and responsive to your company's liquidity needs and risks.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Rana Mohammad Imran Latif

Group Finance Director at RC Almana
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Proper cash management. Timely use cash resources to cover mandatory expenses. Instant cash resources should not be applied for long term investments. Overheads should be optimized and should be tailored with cash resources.

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Felipe Maia Linhares

Finance & Business Planning and Analysis | FMVA®
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Be careful! Liquidity indicators are trick sometimes and be "higher than x" should not be your only source of truth when talking about the liquidity of your company. Try to explore other indicators such as Fleury's tripod on Working Capital, Cash Flow Indexes or times interest earned. You'll notice that sometimes they tell a different story and highlight an invisible potencial risk. That's because liquidity it's not - and shouldn't be - only about capital structure; mix balance sheet indicators with cash-flow and/or income numbers will give you new insights on the health of your business.

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What are the main steps to manage liquidation risk in corporate finance?

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1 Identify the sources of liquidation risk

2 Monitor the liquidity indicators

3 Implement the liquidity strategies

4 Review and adjust the liquidity plan

5 Here’s what else to consider

Corporate Finance

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