Login to your new FMVA dashboard today.

Funding Liquidity Risk

The risk that a company will not be able to meet its short-term financial obligations when due

What is Funding Liquidity Risk?

Funding liquidity risk refers to the risk that a company will not be able to meet its short-term financial obligations when due. In other words, funding liquidity risk is the risk that a company will not be able to settle its bills.

 

Funding Liquidity Risk

 

Understanding Liquidity

Liquidity is defined as the ability to meet immediate and short-term obligations (within a year). As such, funding liquidity risk is the risk that a company is unable to meet its immediate and short-term obligations in a timely manner.

Funding liquidity risk is a major concern for cyclical companies where operating cash flows and debt obligation due dates might not match up perfectly. For example, a company may experience a season of strong performance followed by a season of weak performance. During the period of slowdown, the company may be exposed to funding liquidity risk if the obligations due during that time are greater than the operating cash flows generated. It can be illustrated below:

 

Funding Liquidity Risk

 

In Q3 2020 and Q4 2020, the company may not be able to generate enough cash flows (assuming that they do not keep a cash reserve) to satisfy its debt obligations.

As such, when a company incurs a funding liquidity risk, they face the potential of having to liquidate capital assets (or other operating assets) at a price lower than the market price to satisfy its debt obligations. Selling operating assets would result in severe repercussions on the future revenue generation capabilities of the company.

 

Factors that Increase Funding Liquidity Risk

Funding liquidity risk can be heightened through the following factors:

  • Seasonal fluctuations in revenue generation
  • Business disruptions
  • Unplanned capital expenditures
  • Increased operational costs
  • Poor working capital management
  • Poor matching of asset duration to debt duration
  • Limited financing facilities
  • Poor cash flow management

 

Measuring Funding Liquidity Risk

Liquidity ratios, such as the current ratio and quick ratio, can be used as an indicator of a company’s funding liquidity risk. The current ratio, the most common ratio used to measure such a risk, is shown below:

Current Ratio - Formula

Where:

  • Current Assets are assets that are expected to be converted into cash within a year.
  • Current Liabilities are liabilities that are expected to be due within a year.

 

Additional ratios such as the interest coverage ratio, debt to gross cash flows, quick ratio, etc. should be used to provide a better picture of a company’s funding liquidity risk.

 

Mitigants to Funding Liquidity Risk

To mitigate funding liquidity risk, a company should assess its liquidity position. For example, a company could assess the:

 

1. Extent of dependence on financing

Companies that rely heavily on financing are subject to higher funding liquidity risk. Therefore, it would be important to assess financing facilities and try to minimize unnecessary financing.

 

2. Seasonality of sales

Companies that are cyclical may face poor cash flows in certain periods. Therefore, it would be important to assess cyclical periods of poor cash flows and identify ways to decrease operational costs during those periods.

 

3. Availability of funds

A line of credit is a classic mitigant to funding liquidity risk. A line of credit is a predetermined amount of credit that is extended to a borrower. The borrower would only be charged interest on the amount taken from the line of credit. High availability of funds would help the company to meet debt obligations.

 

Example

A company’s balance sheet is as follows:

 

Sample Balance Sheet

 

From looking only at the balance sheet, what can an investor infer about the company’s funding liquidity risk?

The company shows a current ratio of 0.42x and a quick ratio of 0.40x. Therefore, it would imply that the company faces significant funding liquidity risk.

 

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

  • Business Risk
  • Liquidity Event
  • Overheads
  • Statement of Cash Flows

Financial Analyst Training

Get world-class financial training with CFI’s online certified financial analyst training program!

Gain the confidence you need to move up the ladder in a high powered corporate finance career path.

 

Learn financial modeling and valuation in Excel the easy way, with step-by-step training.