Liquidity risk is associated with illiquid assets; meaning, those that are difficult to turn into cash quickly without generating a loss (in some cases). Funding liquidity risk is a specific type of liquidity risk. It is related to the funds or money coming in that a business has to cover its obligations. In this article, we’ll explore the differences between general liquidity risk and funding liquidity risk.
Liquidity Risk Defined
We’ve discussed liquidity risk and even how to calculate it in previous articles. As a quick summary, liquidity risk is an inability to convert an illiquid asset to cash quickly. Most any asset can be converted to cash quickly, but there can be a loss associated with the conversion.
As an example, a real estate investor who wants to sell one of her properties within the next week probably will have a difficult time accomplishing that task. First, it will take time to complete all of the required paperwork. Second, a buyer at the market rate or satisfactory price will need to be found. Third, there will be a dependency on the buyer to complete all of their paperwork and secure financing as well. Both will likely take much longer than a week.
The investor can speed the process up by dropping the price of the asset. But this can likely mean taking a significant loss. Even if the seller finds a buyer quickly who offers a great price, it will still take time to complete the entire process and receive the cash.
Special Case: Funding Liquidity Risk
Funding liquidity risk is the amount of funds that a business has coming in from operations to pay for its obligations. Specifically for real estate, it is funds coming in from properties (i.e., rent).
From an operational standpoint, any real estate business that does not have enough revenue coming in from its properties to pay for its current obligations will quickly become insolvent. The business will need funding from somewhere else, such as initial investor equity, to pay for its current bills. Operational revenue alone will not do it.
If the business cannot increase its revenue, it will become insolvent. Alternatively, the business can try lowering its cost. It may be able to negotiate a decrease in some costs with vendors, lay off employees, or cut back on other various costs.
Another form of liquidity risk that can be confused with funding liquidity risk is the cash flow gap. This happens when cash coming in at a specific time isn’t enough to cover outstanding obligations. Meaning, the company doesn’t have enough funds to pay for its bills. The cash flow gap is simply a timing issue.
As an example, if a company has net 30 and net 90 day terms on its invoices but vendor bills come in on day 20 and day 75 respectively, the company will be short on cash to pay its bills. It will eventually have the funds but due to timing, it won’t be able to pay its bills on time. A fix to this problem is to try and negotiate better vendor due dates or change its invoice terms to net 15 and net 75 or both.
Funding liquidity risk means that a business is operating inefficiently and on the path to insolvency. There is a mismatch between the amount of money it makes and its obligations. Until those two are brought into alignment, the business plan is flawed.