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Risk Management指导展示
When Liquidity Risk Matters
1.0 Introduction
Risk, as an inherent of doing business, should be paid enough attention by investors before making investment decisions. As it is known to all, there are many uncertain factors in operating activities such as economy condition, unemployed rate, inflation rate, and disposable income and so on (Cnexr, 2004). The change of these factors may bring risk to the companies like management risk, operating risk, marketing risk, etc. At the same time, it will bring financial risk to the companies. In this essay, it will mainly draw a discussion about the liquidity risk in terms of how and when risk arises in finance and how this can be evaluated with the explanations of real-life examples.
2.0 Discuss and analysis
2.1 How liquidity risk arises in financeWith the development of economy and capital market, the invested capital does not adapt the enlarged business scale. In order to solve the capital bottleneck to achieve potential operating successes, more and more companies are financing from different organizations and investors such as banks, individual investors, etc. The more you financed the higher debts paying risk you will meet because there is cost of capital (Jean, 2006). As it is known to all, capital suppliers achieve interest benefits by lending capital to debtors. Thus, there is a pressure for the debtors to repay interest periodic and initial capital. If the operating activities are not performed as expected, the debtors probably do not have the ability to repay interest and capital timely because the uncertain factors in market. At this time, liquidity risk arises due to the continued increased debts. For example, with the rapid development and expansion of Rolls Royce Group for the past several years, the debts proportion in 2007 is 47.15%. In 2008, the indicator is increased to 62.06%. Higher debts proportion means more money of the company is borrowed. If the interest rate rises, more interest should be paid correspondingly. And the company will suffer a tough situation. According to the annual report, the interest cover ratio is increased to 12.39 times from 5.78 times (Martin & Petty, 2005). It means that the debts paying arise.
2.2 When liquidity risk arise in financeAs it is known to all, there must be enough current assets to repay debts timely for companies. Otherwise, the companies may have the liquidity risk. If this financial condition goes on, there may be a bankruptcy risk for the companies (Smith, 2004). Therefore, it can be concluded liquidity risk may arise when there is not enough current assets to repay debts. For example, assume the current debts of a company are almost two times than current assets. And all the current debts should be paid in two weeks. The company does not have enough current assets to repay its debts. Hence, the liquidity risk arises at this condition.
2.3 How liquidity risk can be evaluatedIn order to evaluate the liquidity risk, it can be assessed by two aspects. First, it is the short term liquidity. Second, it is the long term liquidity.
2.3.1 The short term liquidity
There are many financial indicators like current ratio, acid test ratio, etc to be referenced in order to implement the evaluation (Glen, 2001). Generally speaking, if the indicator of current ratio is above 2 times or the acid test ratio is over 1 time of a company, the liquidity risk is thought to be low. For example, Tesco, as a world famous supermarket, has developed rapidly over the past decade by implementing its well established and consistent strategy. Currently, it comes over the liquidity problems due to the excessive business expansion. The current ratio in 2010 is 0.71 times, which is decreased by 0.03 times comparing to 0.74 times in 2009. And the acid test ratio is also decreased by 0.05 times from 0.59 times to 0.54 times (Raviv, 1991). According to the experience data, the liquidity of Tesco is too low to repay debts timely. As a result, there will be a liquidity risk if the current condition goes on.
2.3.2 The long term liquidity
In order to evaluate this index, the most often used indicator is gearing ratio. On the one hand, high gearing reflects the company has bigger ability to make profits with others' leverage. On the other hand, the company will have bigger pressure in operating activities with more debts. For example, Croda, a listed company in UK. The gearing ratio of this company is in the increasing trend from 2008 to 2010. In 2008, the gearing ratio is 31.37%, and this indicator is increased to 58.76% in 2010 (Fama & French, 2005). The gearing is increased due to the loans in order to achieve the expansion strategy. As a result, there is a long term liquidity risk of the company.
2.4 Summary of the discussionAlthough it is not good for the company operates with more debts, the company will achieve benefits in the following terms. First, it can be said the high efficiency management of current assets from another angle (Tarhan, 2003). Because the less current assets in the financial reports, the higher assets turnover of the company will be. That means the higher efficiency of assets management. Second, higher debts ratio reflects the company has big ability to make profits with leverage, especially in inflation environment (Tarhan, 2003).
3.0 Conclusion
Based on the analysis, finance risk is full of operating activities. Every change in operating or finance activities may bring risk to the company. Every thing has two sides, so does finance risk. The company may achieve benefits by bearing high risk such as leverage, increased market shares and so on. Thus, as the deciders of the company, they should have a clear idea about the advantages and disadvantages of making each operating decisions.
4.0 References
Cnexr, P. G. (2004). Market analysis, Journal of Business Venturing, 109, 261-283
Fama, T. F. and French, K. R. (2005). Financing Decisions: A case study about Croda. Journal of Financial and Economics, 76, 49-82
Glen, R. A. (2001). Financial performance Management, New York: Pearson Financial Times/Prentice Hall.
Jean, W. T. (2006). The Theory of Corporate Finance, New Jersey: Princeton University Press.
Martin, J. D. and Petty, J. W. (2005). Foundations of Finance: a case study about Rolls Royce Group, Upper Saddle River, N. J.: Pearson Prentice Hall.
Raviv, J. A. (1991). A case study about Tesco. Journal of Finance, 46(1), 97-125
Smith, Y. R. (2004). Financial and accounting. Academy of financial management, 45, 27-36
Tarhan, H. V. (2003). Corporate financial management. Journal of Corporate Finance, 15, 179-195.
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