How Can Liquidity Risk And Credit Risk Cause Insolvency
Liquidity risk and credit risk are both important measures of a company’s ability to pay its debts. If your business is deemed to have high liquidity or credit risk, then you could struggle to secure credit and pay back existing creditors.
Issues with liquidity and credit are often the first sign that your company is in financial difficulty. If problems persist, you could be at risk of insolvency.
In this article, the team at Irwin Insolvency answers the question: how can liquidity risk and credit risk cause insolvency?
What Are the Causes of Credit Risk?
Credit risk is a term used to describe the risk that a lender attaches to a borrower when they loan them money. Credit risk is effectively the risk that the borrower won’t be able to pay the money back. If this were to occur, the lender would incur disruptions to their cash flow, extra costs or the loss of the money loaned.
Your company may be deemed a credit risk for a variety of reasons. If so, you can expect to pay higher interest rates and be subject to stricter repayment terms if you need to secure credit. The causes of higher credit risk can include:
- A poor credit rating
- Failure to repay loans in the past
- Cash flow problems
- Liquidity risk
What Is the Effect of Liquidity Risk?
Liquidity is defined as being the ease with which assets can be quickly converted into cash. If your company is deemed to be a liquidity risk, it won’t be able to quickly pay off its debts by selling its assets.
Companies may be seen as being a liquidity risk if they have a large number of assets that won’t be easily sold but little cash (cash is the most liquid of assets). The risk becomes a problem when the company has large debts to pay but has inadequate cash reserves.
For example, a tech company could have lots of specialist computing equipment, and so the value of the company might be high. However, it becomes a liquidity risk when it has little cash left in the bank and can’t pay its workers.
For these reasons, liquidity risk is seen as a short-term financial problem. Potential creditors will often measure a company’s liquidity risk to ensure that the money they lend out can be paid back with ease. If your company has high levels of liquidity risk attached to it, you may struggle to secure favourable terms on loans and lines of credit.
What Is the Relationship Between Credit Risk and Liquidity Risk?
Credit risk and liquidity risk are two different types of risk that lenders will consider when approving or declining loans, but it’s important to remember that the two are interlinked. This is particularly important to remember when asking the question, how can liquidity risk and credit cause insolvency?
Simply put, liquidity risk and credit risk have a ‘positive relationship’. This means that if liquidity risk is high, then credit risk will also be high. This positive relationship exists because a high liquidity risk means that the company would struggle to pay back its loans if it begins to struggle financially.
For example, if a company’s liquidity risk has increased, then the company will have a higher credit risk attached to it. Equally, if the same company’s liquidity risk decreases, then its credit risk will also decrease. If a company’s credit risk has decreased, then it’s likely that its liquidity risk also has.
How Can Liquidity Risk Lead to Insolvency Risk?
Insolvency risk is defined as how likely it is that a company will be unable to pay its debts. If a company cannot pay its debts, then it’s said to be insolvent. Insolvency is a serious financial situation to be in and, if not resolved, it can lead to the complete liquidation of a company.
If your company has liquidity risk, this doesn’t mean that it’s immediately also an insolvency risk. However, liquidity risk can eventually lead to insolvency, because the two are interconnected. If your company is rated as having a high liquidity risk, then it’s likely it will also be deemed an insolvency risk.
It’s best to visualise liquidity risk as a short-term problem, while insolvency risk is seen as a longer-term problem. Short-term problems, if ignored or left unresolved, inevitably lead to long-term problems.
Can Liquidity and Credit Risk Cause Insolvency?
Liquidity risk and credit risk are both connected. In turn, these two types of risk are also connected to insolvency risk. An increased liquidity risk or credit risk will lead to a higher risk of insolvency, and this will make it harder for your company to secure lines of credit or loans (at least with favourable interest rates and repayment terms).
It’s important to note that credit risk and liquidity risk are indicators that a company could be at risk of becoming insolvent. They are risks, and as such they won’t directly lead to insolvency.
Insolvency will be caused by negative cash flow, poor sales, or bad management. However, if your company is considered to be a high liquidity risk or high credit risk, this does mean that the company likely has a poor cash flow or is struggling financially. The more risk that is attached to your company, the more difficult it becomes to secure credit, and this makes it much easier for you to default on payments.
Contact Irwin Insolvency Today for More Information on Liquidity Risk and Credit Risk
If your company is facing financial difficulties, the experienced team at Irwin Insolvency are here to help.
We understand the link between liquidity risk, credit risk, and insolvency risk, and can provide expert advice to reduce all three.
If you need further information or more detailed consultation on the question, ‘How can liquidity risk and credit risk cause insolvency?’ contact our team today.