Credit and liquidity risk

Introduction: Why Credit and Liquidity Risk Matter

Welcome to this chapter! In the world of Financial Management, cash is the lifeblood of any business. While companies often focus on making profits, many businesses fail not because they weren't profitable, but because they ran out of cash or weren't paid by their customers. That is exactly what Credit Risk and Liquidity Risk are all about.

In this chapter, we will explore the nature of these risks and, more importantly, compare the different methods used to manage them. Since the HKICPA exam is now 100% Objective Type Questions (OTQs), you need to be able to identify these risks in a scenario and decide which management technique is best suited for the situation.

Don't worry if this seems a bit technical at first—we'll break it down using simple analogies that make sense in everyday life!

1. Credit Risk: Will I Get My Money Back?

Credit Risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. In a business context, it usually refers to the risk that your customers (trade debtors) won't pay their invoices.

The "Lending a Friend Money" Analogy: Imagine you lend \( \$1,000 \) to a friend. Credit risk is the chance that your friend moves away and stops answering your calls before paying you back. You still have the "profit" (the promise of the money), but you don't have the actual cash!

Methods of Managing Credit Risk

As an Associate Level student, you must be able to explain and compare these methods:

• Credit Assessment (Vetting): Before giving credit, check the customer's history. In Hong Kong, businesses might check bank references or use credit agency reports.
  Pros: Prevents bad debts before they happen.
  Cons: Can be slow and might turn away potential customers if the criteria are too strict.


• Setting Credit Limits: Placing a "cap" on how much any single customer can owe.
  Pros: Limits the maximum loss (exposure) from one customer's failure.
  Cons: May restrict sales growth for your best (but high-volume) customers.


• Credit Insurance: Paying a premium to an insurance company that will pay you if your debtor defaults.
  Pros: Transfers the risk to a third party; provides peace of mind.
  Cons: Expensive premiums; insurers often refuse to cover "high-risk" customers.


• Factoring and Forfaiting: Selling your accounts receivable to a third party (a factor) at a discount for immediate cash.
  Pros: Immediate cash flow; the factor often takes over the "hassle" of debt collection.
  Cons: Can be expensive (the discount rate); might signal to customers that you are in financial trouble.


• Collateral and Guarantees: Asking for an asset (like property) or a bank guarantee as security.
  Pros: Very high security; you can seize the asset if they don't pay.
  Cons: Many customers (especially small ones) cannot provide collateral.

Quick Tip: If an exam question asks for the "most certain" way to eliminate credit risk, it’s usually cash on delivery (COD)—but remember, this isn't always practical in a competitive business world!

Key Takeaway: Credit risk management is a balancing act between minimizing losses and maximizing sales opportunities.

2. Liquidity Risk: Can I Pay My Bills Today?

Liquidity Risk is the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities. In simpler terms: you have bills to pay today, but your money is tied up in assets that you can't sell quickly.

The "ATM Analogy": Imagine you have \( \$1,000,000 \) in a fixed-term deposit account that you can't touch for a year. You go to a restaurant and the bill is \( \$500 \). You are technically a millionaire, but if you don't have \( \$500 \) in your wallet or a liquid bank account, you have a liquidity problem!

Types of Liquidity Risk

1. Funding Liquidity Risk: The risk that you cannot settle obligations as they fall due (e.g., can't pay staff salaries this month).
2. Market Liquidity Risk: The risk that you cannot sell an asset quickly at its fair market price (e.g., trying to sell a factory in 24 hours usually requires a massive price cut).

Methods of Managing Liquidity Risk

To succeed in Module 7, you should understand how these methods compare:

• Cash Flow Forecasting: Regularly predicting future cash inflows and outflows.
  Why it works: Acts as an "early warning system" so you can arrange financing before a shortage hits.


• Maintaining a "Buffer" of Liquid Assets: Keeping a portion of wealth in cash or "near-cash" items (like HK government exchange fund bills).
  Pros: Instant access to funds.
  Cons: "Idle" cash earns very little interest compared to investing it in the business.


• Committed Credit Lines: An agreement with a bank (like an overdraft facility) where they guarantee to lend you money up to a certain limit whenever you need it.
  Pros: You only pay interest when you use it; provides a safety net.
  Cons: Banks charge "commitment fees" just to keep the facility open.


• Working Capital Management: Speeding up how fast you collect money from customers and slowing down (within reason) how fast you pay suppliers.
  Pros: Improves liquidity without external borrowing.
  Cons: Paying suppliers too slowly can damage your reputation or lead to lost discounts.

Did you know? In the Hong Kong banking system, the Liquidity Maintenance Ratio (LMR) is a key requirement for banks to ensure they always have enough "liquid" assets to survive a sudden withdrawal of funds by depositors.

Key Takeaway: Liquidity risk management is about ensuring the timing of cash coming in matches the timing of cash going out.

3. Comparing Management Methods: Summary Table

When you face an OTQ (Objective Type Question) scenario, use this logic to compare methods:

4. Common Pitfalls to Avoid

• Confusing the two: Remember, Credit Risk is about others paying you. Liquidity Risk is about you paying others.
• Ignoring the Cost: Every risk management method has a cost (e.g., insurance premiums, bank fees, or lost interest). In the exam, the "best" method is often the one that balances cost and safety most effectively.
• Solely relying on Profit: A company can be profitable (\( Net Income > 0 \)) but still go bankrupt because of liquidity risk if all its "wealth" is tied up in unsold inventory.

Quick Review Box

1. Credit Risk: Risk of counterparty default. Manage via vetting, limits, insurance, and factoring.
2. Liquidity Risk: Risk of insufficient cash for obligations. Manage via forecasting, liquid buffers, and credit lines.
3. Trade-off: More safety usually means lower returns (cost of insurance or idle cash).
4. HK Context: Local businesses rely heavily on banking relationships for liquidity (overdrafts) and credit assessments.

Great job! You've now covered the essentials of Credit and Liquidity risk for your Financial Management module. Keep practicing those scenario-based questions!