Risk Management-Liquidity Risk
Liquidity risk occurs when cash is locked up in some parts of the business. Hence, the company is unable to pay its short-term debt obligations.
A simple illustration is a business having a significant forecast from a client resulting in a high inventory of a specific product. The order is cancelled due to default of the client, causing the small amount of cash the business had locked in unsold inventory. At the same time, the company needs to pay its short-term debt. The only way to move forward is to sell the product at a substantial discount resulting in a loss.
Another example, linked to credit risk and lower down the chain, is bad debt derived from poor credit management. If the company has a low cashflow and counted on this client payment to repay short-term debt, it will not be able to do it, resulting in the business put at risk.
Liquidity Risk Management Solutions
The high cash-intensive operation should be adequately considered with all its implication before being made. Businesses must practice proper and strategic cash flow management. It will prevent the company from being put in the uncomfortable position of having trouble to pay its short-term debt.
Monitoring the liquidity of the company can be the start. Tools such as financial ratio comparing the short-term assets to short-term liabilities should be put into place and kept an eye on.
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