Overview
Liquidity risk is the risk that a solvent company is unable to pay its liabilities because it has run out of cash.
It is considered to be one among the list of common enterprise risks.
Cash Sources and Sinks
The first step in doing a liquidity analysis is to list out the sources and sinks of cash in the organization.
- Contractually Defined Cash Flows
- are cash flows that are specified in some contract to which the company is a party to, and can be known
exactly in advance. Typically includes
- Employee Salary
- Outstanding Debt Obligations
- Fixed Income securities held by the company
- Expected Cash Flows - generally refers to cash flows that are not known in advance. The primary cash flow in this category is usually sales, but can include expenses as well.
Forecasting Cash Flows
Once a company has listed its sources and uses of cash, it can then proceed to try to forecast the company's liquidity position in the future.
The following represent two different types of analysis that can be performed to forecast a company's cash flows.
- Expected Value Forecast - a simple calculation which tries to calculate a single forecast that represents the expected cash balances over time.
- Monte Carlo Simulations - attempts to capture the statistical nature of cash balances by simulating a number of different scenarios.
Topics
- Financial Liquidity Ratios - simple financial ratios used to gauge a company's cash position.