Which scenario illustrates high liquidity risk?

Which scenario illustrates high liquidity risk?

• A. A firm with substantial cash reserves
• B. A firm that relies heavily on borrowed capital
• C. A firm consistently increasing its revenue
• D. A firm diversifying its investment portfolio

Answer: (B)

A scenario illustrating high liquidity risk is one where a firm relies heavily on borrowed capital. This reliance can lead to liquidity issues because the firm may have significant obligations to repay loans, which could strain its cash flow, especially during downturns or periods of decreased revenue. When a firm utilizes borrowed funds, it is often required to make regular interest payments and ultimately repay the principal amount, which can create pressure on its available cash reserves. If the firm encounters unexpected expenses or economic challenges, its ability to meet these obligations without liquidating assets or incurring additional debt can be severely compromised. Consequently, this situation increases the likelihood that the firm will struggle to maintain adequate liquidity, ultimately leading to higher liquidity risk.

A scenario illustrating high liquidity risk is one where a firm relies heavily on borrowed capital. This reliance can lead to liquidity issues because the firm may have significant obligations to repay loans, which could strain its cash flow, especially during downturns or periods of decreased revenue. When a firm utilizes borrowed funds, it is often required to make regular interest payments and ultimately repay the principal amount, which can create pressure on its available cash reserves. If the firm encounters unexpected expenses or economic challenges, its ability to meet these obligations without liquidating assets or incurring additional debt can be severely compromised. Consequently, this situation increases the likelihood that the firm will struggle to maintain adequate liquidity, ultimately leading to higher liquidity risk.