liquidity risk refers to the risk of:
a. Foreign currency fluctuations
b. High volatility in stock prices
c. A firm being unable to meet short-term financial obligations
d. An asset’s price falling drastically
The correct answer and explanation is:
Correct Answer: c. A firm being unable to meet short-term financial obligations
Liquidity risk refers to the danger that a company or individual may not have enough cash or liquid assets to meet short-term obligations when they come due. It arises when an entity cannot convert its assets into cash quickly enough to satisfy immediate financial demands, such as paying debts, salaries, or suppliers.
This type of risk is especially concerning for businesses that operate on tight cash flow margins. If they cannot access sufficient liquid funds, even temporarily, it can lead to serious operational issues or even bankruptcy. Liquidity risk does not necessarily mean that the firm is insolvent; it may have valuable assets but still struggle to turn them into cash quickly.
There are two main types of liquidity risk. The first is funding liquidity risk, which relates to the firm’s inability to meet its short-term obligations. The second is market liquidity risk, which occurs when an asset cannot be sold rapidly in the market without a substantial drop in its price.
For example, a business may own valuable equipment or real estate, but if it needs cash urgently to pay an upcoming loan installment or supplier invoice, it cannot use these illiquid assets quickly. This may force the firm to borrow at high interest rates or sell assets at unfavorable prices.
Strong cash management practices, maintaining adequate cash reserves, and having access to credit lines are common ways to reduce liquidity risk. Financial institutions often monitor liquidity closely because it is a key indicator of a company’s financial health and its ability to survive unexpected events. Failure to manage liquidity risk properly can lead to reputational damage, reduced investor confidence, and in severe cases, business failure.