How Can Liquidity Risk And Credit Risk Cause Insolvency?
A company is declared insolvent when they can no longer pay their debts as they fall due (i.e their liabilities are greater than their assets). There are many factors that contribute to a company becoming insolvent, however two factors that are likely to have a particularly large impact are liquidity risk and credit risk. How can liquidity risk and credit risk cause insolvency? Let’s find out.
What Is Liquidity Risk?
In order to answer the question of ‘how can liquidity risk and credit risk cause insolvency’, it’s important to define what each of these terms mean, starting with liquidity.
Liquidity refers to the ability to convert an asset into cash quickly. This involves being able to sell the asset at a reasonable market price and without causing the company a significant financial loss. So, when a business director or shareholder cannot convert an asset into cash quickly, they face liquidity risk. This becomes an issue when a business cannot raise the funds it needs to pay an outstanding debt due to being unable to release cash quickly enough from its assets.
What Is Credit Risk?
When a borrower is given funds from a lender, there is always a risk that they will be unable to repay the funds in full and on time. That’s why, it’s important for lenders to assess the risk as accurately as possible. Credit risk refers to the ability, or indeed, inability, of a borrower to make these outstanding debt payments on time. The risk is assessed by looking at the borrower’s credit history, financial statements, exposure to investments and ability to raise capital. The lower the risk, the more likely it is deemed the company will be able to repay its debts as they fall due.
Now that we’ve defined what we mean by credit and liquidity risk, let’s go back to our initial question: How can liquidity and credit risk cause insolvency?
Liquidity, Credit Risk And Insolvency
As we mentioned earlier, a company is insolvent when it is unable to pay its debts as required. If liquidity risk is high, this means that the company cannot raise enough cash through the sale of its assets to meet debt payments. If credit risk is high, this means that it is probable, based on analysis of the business’ finances, that it will be unable to pay its debts on time.
So, to go back to the question of ‘how can liquidity risk and credit risk cause insolvency?’, the answer is quite direct. If credit and liquidity risks are high, then a business will struggle to pay its debts. If a business cannot pay its debts, it is insolvent.
How Can You Manage Credit And Liquidity Risks?
We’ve determined that the answer to the question ‘how can liquidity risk and credit risk cause insolvency?’, is by these risks preventing a company from being able to pay its debts. Now, you’re likely to be wondering how you can prevent this from occurring.
The key to managing these risks is to monitor your business’ finances closely and constantly. This will allow you to spot potential risks early on and prevent them from reaching a point where you are unable to pay outstanding debts.
If you are concerned about your business’ credit or liquidity risk, and would like further guidance, please don’t hesitate to contact our experienced team of licensed insolvency practitioners for confidential advice.
