1.1 Liquidity risk
Liquidity risk applies to all organisations. International Financial Reporting Standards (IFRS, 2010, p. 12) deﬁnes liquidity risk as the risk that an entity will encounter difﬁculty in meeting obligations associated with ﬁnancial liabilities that are settled by delivering cash or another ﬁnancial asset. Such circumstances may signal the termination of the business with the organisation required to cease trading, wind up the business and distribute the residual assets to creditors in accordance with their ranking. Alternatively, a liquidity crisis could result in a major restructuring of the ﬁnancial base of the organisation – either through the taking on of new debt or through a new share issue.
The way liquidity risk can be (or has to be) managed varies between different sectors and may also reflect the size of the organisation. For small organisations, management of liquidity risk often comes down to cash ﬂow management over a fairly short time period. With no long-term debt, such organisations may ﬁnd that liquidity problems simply arise through mishandling of its trade ﬂows – having to meet obligations to creditors or suppliers ahead of receipt of payments by customers. Indeed, many businesses manage their cash ﬂows with the intention of using them to provide liquidity by operating with ‘negative working capital’. This is where the outstanding amounts due to creditors, or accounts payable, exceed those due to be received from debtors, the accounts receivable, plus the ﬁnancial value of inventory. In these circumstances, the organisation’s creditors are, in effect, providing free ﬁnance for the business! This ideal situation is unfortunately difﬁcult to achieve in the real world.
Even for larger organisations – particularly those with large daily ﬂows of business and a high number of suppliers, such as supermarkets – there is exposure to the risk of mismanagement of the cash ﬂows arising from business operations.