Today’s post will wrap up our discussion on risk management before we move onto a different topic. The last key component of financial risk that I want to highlight to you is liquidity risk.
This is the risk that your business will be unable to pay its own debts or fulfill its own financial obligations. For any accounting people out there, a business is faced with this risk any time it takes on a liability. For the non-accounting folks, this risk arises whenever you enter into a contract, agreement, or transaction that requires you to expend financial resources at any point thereafter.
Here’s a mini case study to illustrate this risk and to determine the optimal response to it:
Rex’s Records (RR) sells rare vinyl music records out of a storefront they lease in the trendy part of the Queen Street West neighbourhood in Toronto. RR’s core business involves them acquiring expensive, highly sought-after vinyl records. As you can imagine, these records can take a long time to sell as they need the right buyer to come along.
RR faces liquidity risk resulting from the significant time delay between making sales and buying inventory, paying wages/bills/etc. This can make it difficult to meet their financial obligations.
Now let’s go through our usual arsenal of response options to identify which work, which don’t, and why.
This response doesn’t really fit this situation, as most businesses cannot truly/fully avoid liquidity risk. There will always be a delay between making sales and paying bills, and that delay becomes considerable when you’re talking about niche products like RR’s rare vinyls.
Again, this response isn’t really valid given our situation - you can’t buy insurance against this or rearrange the business to effectively transfer this risk to the customer, supplier, or another party.
To some extent, yes, every business owner will have to accept some level of liquidity risk as part of their normal business operations, but to select this option means to take no steps to decrease RR’s risk exposure or tip the odds in your favour of not letting it ruin your business. Long story short: we can do better, so let’s move on.
Now we’re talking! There are a few options for RR to pursue to help mitigate its exposure to liquidity risk, but the most effective of these does involve making some changes to the business itself. If you look to your own neighbourhood, you may know of a vinyl music store but it is far less likely to see a store offering only rare vinyls - the reason for this is that this niche is often too narrow to support a traditional brick-and-mortar business (online-only business owners, here’s where you can grin smugly).
Instead, RR would need to broaden their scope in an attempt to capture more of the market, specifically by selling other products that have a faster turnover (turnover is an industry term that describes how fast it takes a product in inventory to be sold and converted into cash). Products with a high turnover help to decrease liquidity risk by decreasing the time lag from when they are purchased until they are sold - that means more cash is available more often to help pay down liabilities. Some examples include more common, lower priced vinyl records, headphones, music/recording equipment, stereos, etc.
And that brings us to the end of our discussion on risk for now. If you have questions on the risks faced by your business or how to best respond to them, just reach out in the comments.