Liquidity risk poses a direct challenge to a company’s operational continuity and financial stability. Failure to manage liquidity risk can have severe consequences, potentially turning a profitable company into an insolvent one.

From the perspective of corporate treasury, managing liquidity risk is central to safeguarding a company’s ability to fund its day-to-day operations. This page explores what liquidity risk is, why managing it is so crucial for treasury and how treasury professionals can leverage best practices to mitigate it.

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• Understanding Types of Liquidity Risk
• Challenges Treasury Professionals Face with Liquidity Risk
• How to Measure and Monitor Liquidity Risk
• Strategies for Mitigating Liquidity Risk
• Proactive Liquidity Risk Management for Treasury Leaders

What Is Liquidity Risk? Meaning, Definition & Importance in Treasury

Liquidity risk is the risk that an entity becomes unable to meet short-term financial obligations because it cannot quickly and easily convert sufficient assets or securities into cash without incurring a substantial loss in value.

Mitigating liquidity risk is paramount to a company's viability. Failure to have enough liquidity to meet short-term financial obligations can result in late payments, increased debt, and potentially even insolvency or bankruptcy if the company’s financial health does not improve.

Understanding Types of Liquidity Risk: Funding vs. Market Liquidity Risk

Liquidity risk is typically divided into two types: funding liquidity risk and market liquidity risk.

What Is Funding Liquidity Risk?

Funding liquidity risk refers to the risk that a company will not be able to raise the necessary cash to meet its short-term financial obligations when they are due. It is impacted by a company’s ability to raise short-term and long-term capital in a timely manner.

An example of exposure to funding liquidity risk is a corporation with an active commercial paper program that continually rolls over commercial paper. Many factors, such as a reduction in a company’s credit rating, narrowing spreads in short-term credit or deterioration in the credit markets, can affect a company’s ability to refinance commercial paper.

What Is Market Liquidity Risk?

Market liquidity risk, also known as asset liquidity risk, refers to the risk that an asset cannot be sold quickly at, or close to, its true value. Companies that hold portfolios of investment assets are especially affected by this type of risk, even more so if the assets they hold are not fully liquid due to the type of asset. Extraordinary market conditions create additional risk as well.

An example of exposure to market liquidity risk is a corporation holding portfolios of investment assets that are not fully liquid, such as mortgage-based securities. Extraordinary market conditions can also add risk. For example, at the height of the Covid-19 pandemic, the commercial paper markets were illiquid.

Challenges Treasury Professionals Face with Liquidity Risk

More than 57% of treasury professionals reported that liquidity risk is the most challenging financial risk to manage, according to the 2023 AFP Risk Survey. And of those who found liquidity risk to be the most challenging, there was a higher percentage of smaller companies and privately held companies.

Treasury professionals often rely on bank loans or capital market instruments to help them manage their liquidity. Those at smaller companies or privately held companies may not have the same level of access to capital as larger companies or public companies, making liquidity risk management even more challenging.

How to Measure and Monitor Liquidity Risk

Mitigating potential liquidity risk starts with having a comprehensive view of a company’s liquidity position. Treasury professionals should monitor the following liquidity metrics to help them identify liquidity pressures.

Current Ratio

Current Ratio = Current Assets / Current Liabilities

Also known as the working capital ratio, the current ratio represents a company’s ability to meet its short-term debt obligations with its current assets (i.e., cash and other liquid assets that are expected to become cash in one year or less). Working capital is an important lever for liquidity management, and the current ratio is a key indicator of a company’s short-term financial health. A higher current ratio typically indicates less risk of a company being unable to fulfill its short-term obligations.

Quick Ratio

Quick Ratio = (Cash + Short-Term Investments + Accounts Receivable) / Current Liabilities

Also known as the acid test ratio, the quick ratio is a more stringent measure of liquidity than the current ratio because it excludes inventory and prepaid expenses. The higher the value of the quick ratio, the less risk of a company being unable to fulfill its short-term obligations.

Cash Ratio

Cash Ratio = (Cash + Short-Term Investments) / Current Liabilities

The cash ratio is the most conservative measure of liquidity in this section, as it demonstrates a company’s ability to fulfill its short-term obligations using only the most liquid assets. Though benchmarks vary by industry, a “good” cash ratio typically falls between 0.50 and 1.0.

Operating Cash Flow Ratio

Operating Cash Flow Ratio = Cash Flow from Operating Activities / Current Liabilities

The operating cash flow ratio represents a company’s ability to cover its short-term obligations using cash generated from its core business operations. Though benchmarks vary by industry, a “good” operating cash flow ratio is typically greater than 1.0.

Cash Conversion Cycle

Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding

While the liquidity ratios discussed above capture a static view of a company’s liquidity position, the cash conversion cycle (CCC) provides a dynamic view. It represents the amount of time it takes to convert cash outflows associated with production into cash inflows through the collection of accounts receivable. Generally, companies want to have a shorter CCC, as it means cash is tied up for a shorter period of time in the operating cycle, thereby reducing liquidity risk.

Strategies for Mitigating Liquidity Risk

A strong liquidity risk management framework requires a combination of strategies that create defensive buffers, diversify funding sources and optimize the balance sheet.

Establish and Maintain Cash Reserves

The most fundamental liquidity risk management strategy is maintaining a sufficient buffer of cash and high-quality liquid assets. When a company experiences unexpected cash flow shocks, such as a sudden drop in sales or an unforeseen capital expenditure, its cash reserves act as a first line of defense.

The optimal amount of cash to hold in reserves depends on a company’s specific risk profile. A common rule of thumb is to have enough cash to cover three to six months of operating expenses.

Diversify Funding Sources

Relying on a single bank or a single type of funding exposes a company to significant liquidity risk in the case of counterparty failure, market stress or sector-specific downturns. A diversified funding strategy should include a range of funding instruments that extend beyond loans and lines of credit. For larger organizations, the commercial paper market can offer an alternative avenue for short-term funding.

Additionally, having multiple relationship-based banking partners for revolving credit lines ensures that even if the lending appetite of one financial institution changes, a company will still have access to committed liquidity.

Build a Debt Maturity Ladder

A significant source of liquidity risk is having a large concentration of debt due within a short timeframe. If a company needs to refinance, it’s forced to refinance a large amount of debt at a specific point in time, regardless of the prevailing market conditions. Spreading debt maturities out allows companies to refinance smaller amounts of debt on a rolling basis.

Shorten the Cash Conversion Cycle

Beyond relying on external funding sources, working capital management with a focus on shortening the CCC can help treasury professionals unlock internal liquidity, making the company more resilient.

Converting sales into cash more quickly reduces the amount of working capital trapped in the operating cycle. This freed-up cash can be used to meet debt obligations without having to borrow externally, enhancing the company’s liquidity position.

Proactive Liquidity Risk Management for Treasury Leaders

Once a treasury function has established a solid foundation of core liquidity risk mitigation strategies, the next step is to develop a forward-looking framework that includes:

• Cash flow forecasting to anticipate cash shortfalls or surpluses, enabling the treasury team to make informed decisions well in advance. The integration of artificial intelligence (AI) and machine learning (ML) is transforming forecast accuracy by identifying complex patterns that traditional models might miss.
• Stress testing, an analytical exercise that assumes a severe but plausible adverse change in one or more of an organization’s funding sources and assesses the resilience of a company’s liquidity position. This process identifies potential vulnerabilities before a crisis occurs.
• A contingency funding plan (CFP), a pre-approved playbook that applies findings from stress tests to detail how a company will respond to a liquidity crisis. A comprehensive CFP defines governance and oversight, connects to a set of early warning indicators, outlines specific actions the company will take to generate liquidity at various stages of a crisis, includes a communication strategy for key stakeholders, and follows a testing and maintenance schedule.

Given the evolving economic landscape, it’s also important to regularly review and update liquidity policies and procedures to ensure they account for emerging risks. According to the 2025 AFP Liquidity Survey, underwritten by Invesco, 82% of organizations with written cash investment policies review them on a regular basis.

Liquidity impacts every major business decision, so to effectively influence underlying cash flow drivers and proactively mitigate risk, treasury needs to forge strong partnerships across the business. Furthermore, treasury leaders can position themselves as strategic advisors to the C-suite by leveraging insights from forecasts, liquidity analyses and stress tests to inform decision-making.

Looking ahead, heightened volatility and the acceleration of technological advancement make continuous learning even more of a priority for treasury teams seeking to future-proof their liquidity risk management strategies.

Treasury professionals can continue their education on liquidity risk management through:

• AFP 2025, October 26-29, in Boston, the premier conference for treasury and finance professionals, with 140+ educational sessions across seven tracks.
• AFP Treasury Connect: Next-Level Treasury Operations, a complimentary virtual half-day event on September 10, 11 AM – 2:40 PM ET, that features a session on aligning liquidity planning with enterprise-wide financial strategies and risk tolerance.