IM CK PHEY.docx

When an entity, organization, or firm is unable to fulfill its short-term monetary obligations due to inadequate money or a lack of ability to change possessions into cash quickly with no significant loss, that is referred to as liquidity risk. The risk may arise because of market volatility, unfore...

When an entity, organization, or firm is unable to fulfill its short-term monetary obligations due to inadequate money or a lack of ability to change possessions into cash quickly with no significant loss, that is referred to as liquidity risk. The risk may arise because of market volatility, unforeseen expenses or withdrawals, or a sudden increase in liabilities. The liquidity risk problem lies in the fact that there is a mismatch between assets and liabilities where assets cannot be easily sold at their market value in order to meet immediate financial needs. **Importance of Liquidity** - Liquidity introduces some of the most important financial flexibilities, which would help both an individual and an organization cater to changes in their financial circumstances. - When things change or financial needs increase, a stipulated level of cash and other liquid assets is always handy to finance unwarranted events, emergencies, or medicine-taking sudden business opportunities. - Liquidity retains long-term financial stability for one reason---it protects against selling long-term and illiquid assets when market conditions are not conducive or favorable, thereby halting possible financial ruin. **Types of Liquidity** 1. Market Liquidity  Market liquidity is the measure of how easily an asset can be turned into money without impacting its price considerably. Liquidity risk comes about when a company is not able to engage in transactions at market prices due to shallow markets, few buyers, or other disruptions in the marketplace. This kind of risk is particularly high in less liquid markets, where differences between supply and demand make large trades hard to implement at fair prices. In one case, trying to dispose of a large number of stocks belonging to thinly traded stocks might result in a sharp fall in share price, thus leading to a loss for the seller. 2. Funding Liquidity Funding liquidity risk is the obstacle that an organization encounters in acquiring the required funds to meet its short-term financial obligations. The source of this threat normally arises from poor cash management, creditworthiness problems, or unfavorable market conditions that discourage lenders and investors from offering any help. For instance, even entities with sound financial positions may have problems securing short-term financing on favorable terms during periods of financial instability. **The Importance of Maintaining Adequate Liquidity** - Risk Mitigation - Enough liquidity is vital in managing risks associated with market fluctuations, unexpected expenses, and economic recession. It can be considered a cash buffer, which can support individuals and businesses during financial instability without having to sell assets or take loans at unfavorable rates. - Operational Efficiency - Businesses need adequate liquidity to function effectively. This supports the timeliness of paying suppliers, workers' wages, and other operational costs so as not to hinder business operations. - Investment Opportunities: Adequate liquidity, besides positioning both businesses and investors to profit from developing chances for investments, can be achieved because liquid assets are available, and thus they can act promptly during times when market conditions are favorable in order to improve their growth and potential profitability. **Consequences of Inadequate Liquidity** - Insolvency Risk - Insufficient liquidity increases the insolvency risk, as a company may find it challenging to meet its short-term financial obligations. Inability to pay off immediate liabilities may affect the firm's normal functioning and cause financial instability. - Forced Asset Sales - Lack of enough money can sometimes force firms into selling their assets at unfavorable conditions, which are usually lower than market prices. As a result, financial losses will be realized, thereby making the position of the company even weaker financially. **Managing Liquidity** 1. Liquidity Management Strategies - Maintaining cash reserves - Establish an adequate amount of cash that can be used to deal with reduced revenue scenarios as well as late payments so that the organization can continue operating. - Diversifying funding sources - The company should diversify its funding sources by relying on multiple channels such as loans from banks, credit facilities, shares, and bond issues, thereby reducing exposure to a single source of finance for stability reasons. - Managing receivables and payables efficiently - One can manage the cash conversion cycle through the timing of receivables and payables. This can be accomplished by increasing the speed at which one receives money and, at the same time, slowing down money issuance to improve liquidity without deteriorating operational efficiencies. 2. Liquidity Planning - Cash Flow Forecasting - Do an estimate of cash flow on a regular basis to project the amount of liquidity required in the future. It would also give a rough idea of the inflow and outflow of cash in the near future, so that one will be better prepared for times of high or low demand for liquidity. - Identifying Liquidity Gaps - Analyze timing mismatches between expected cash inflows and required payments. This assists in finding potential liquidity gaps or excesses in order to make adjustments well in advance. - Diversifying Liquid Assets - Keep a variety of liquid assets such as money, marketable securities, and short-term investments. Such a diversity guarantees easy access to finances when unexpected financial difficulties arise hence enhancing flexibility. References: Kenton, W. (2023, October 11). *Learn about liquidity risk with investments*. Investopedia. https://www.investopedia.com/terms/l/liquidityrisk.asp admin. (2023, September 12). *Why is liquidity important?* Factris. https://www.factris.com/en/news/why-is-liquidity-important/\#:\~:text=Liquidity%20provides%20financial%20flexibility. Brunnermeier, M. K., & Pedersen, L. H. (2009). Market Liquidity and Funding Liquidity. The Review of Financial Studies Drehmann, M., & Nikolaou, K. (2013). Funding liquidity risk: Definition and measurement. Journal of Banking & Finance Berger, A. N., & Bouwman, C. H. S. (2009). Bank Liquidity Creation. The Review of Financial Studies Acharya, V. V., & Viswanathan, S. (2011). Leverage, Moral Hazard, and Liquidity. The Journal of Finance Myers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics Diamond, D. W., & Dybvig, P. H. (1983). Bank runs, deposit insurance, and liquidity. Journal of Political Economy Shleifer, A., & Vishny, R. W. (1992). Liquidation Values and Debt Capacity: A Market Equilibrium Approach. The Journal of Finance Van Horne, J. C., & Wachowicz, J. M. (2009). \*Fundamentals of Financial Management\* (13th ed.). Prentice Hall. Matz, L., & Neu, P. (2007). \*Liquidity Risk Measurement and Management: A Practitioner's Guide to Global Best Practices