Thursday, January 9, 2014

Risk Management: Liquidity Risk Part 1

Liquidity risk is simply the risk of not being able to prepare enough cash in time to meet obligations when they fall due. Just like a compulsive gambler who can’t pay the loan sharks when they come to collect, companies or investors will get fucked up if they can’t meet their obligations on time. In part 1 of the liquidity risk series, I will be discussing liquidity risk in relation to the company. I will be discussing the individual investor’s liquidity risk in part 2 of this series.

A company with high liquidity risk could be forced to borrow at high rates or issue shares at depressed prices to raise the cash necessary to keep its business running. In the really bad cases, companies can go bankrupt if they don’t have adequate liquidity. One way to test if a company has adequate liquidity is to calculate its quick ratio. The quick ratio is simply:

 (cash and equivalents + marketable securities + accounts receivable)
                                Current Liabilities

Inventories and other current assets are not included in the calculations of the quick ratio as it takes a longer time to convert them into cash. There is also a higher risk of having to take a loss on current assets such as inventories when you try to sell them off quickly. A company with a higher quick ratio is in a better position to meet its short-term obligations as it has a higher margin of safety; the company may still be able to pay its short-term liabilities even if it can’t convert some of its current assets into cash on time. I generally would require a company to have a quick ratio of at least 1.5 before I invest in it. That way my dreams of Victoria’s Secret models won’t be replaced by nightmares of bankruptcy.

Of course we shouldn’t just take the quick ratio at face value. We need to dig deeper and look at the company’s short-term investments portfolio to see if it consists of securities that can quickly and reliably be sold at no or minimal losses. A company with a portfolio mainly consisting of stocks or other volatile securities may not have as much liquidity as its quick ratio indicates. This is the case as the volatile securities may drop in price in the future which reduces the amount of cash the company can raise from selling those securities. The company will also take a permanent hit to its equity capital if it had to realize losses and sell its volatile securities at depressed prices to raise cash to meet its obligations. This of course weakens the company’s financial position and destroys shareholder value.


Don’t worry my fellow value investors. I haven’t gone full retard like some academics. When I say that stocks and other securities such as lower grade corporate bonds are volatile, it’s simply an observation. Unlike some dumb sons of bitches, I don’t believe I can control or estimate the volatility of these securities using volatility measures such as Beta and correlation coefficient. I just make sure to factor in a haircut on these securities when including them in my liquidity calculations.


We also need to calculate the “days sales outstanding” figure which is the number of days it takes for a company to collect on its accounts receivable.  A company with a significantly higher “days sales outstanding” figure as compared to its peers indicates that the company is in a worse position liquidity-wise than what its quick ratio tells us. This is the case as a days sales outstanding figure that’s higher than average could mean that the company is having difficulties in getting customers to pay up. Such a company runs a higher risk of not being able to convert its accounts receivable into cash as planned and could find itself being short on cash when its liabilities fall due.

Companies often rely on credit facilities to help them with their liquidity. Investors should look through the annual report to find out how secure a company’s credit facilities are. Will the banks leave the company with its dick in its hands when things get rough?   

Sometimes a company may have a low quick ratio but still have adequate liquidity because it has a negative cash conversion cycle. In other words, the company is able to sell its products and collect on its accounts receivable long before it needs to pay its suppliers. Keep a look out for these companies as they are generally of really high quality.  

For companies with a lot of borrowings (bonds, bank loans & other debt securities), I would also look at when its debts mature. If there’s a large chunk of its borrowings maturing within the next few years, I need to be reasonably confident that the company can raise enough cash to pay them off. I will look at the company’s current cash & marketable securities holdings and its free cash flow to estimate its ability to pay off its debts that are maturing in the next few years. Yes, I know that companies usually refinance their debts. But I need to be confident that the company can still pay its maturing debts if banks stop lending and the debt markets can’t be tapped.  It’s just like how a middle-aged man always makes sure that he has some Viagra stocked up. That way the dude can be reasonably confident of getting some action even if his dick doesn’t get hard naturally.   Investors should also find out if the company has any significant obligations such as large contracted capital expenditures in the short to medium term.    


Well, this concludes part 1 of the liquidity risk series. Thanks for sticking with me till the end. Take care and stay rational! 

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