What is true about the correlation between liquidity risk and a company’s cash flow?

Choosing to associate higher liquidity risk with fluctuating cash flow captures a fundamental aspect of financial management. Liquidity risk pertains to the possibility that a company may not be able to meet its short-term financial obligations due to an inability to convert assets into cash quickly enough or without significant loss.

When a company experiences higher liquidity risk, it often indicates that its cash flow is not consistent or reliable. Fluctuating cash flow can result from several factors, such as unpredictable revenue streams, seasonality in sales, or operational issues that can affect liquidity. Therefore, when cash flows are erratic, the risk of encountering liquidity problems escalates, making it difficult for the company to maintain sufficient cash reserves for necessary expenditures.

This understanding reflects the interconnectedness of liquidity and cash flow management in a business context, highlighting the importance of maintaining stable cash flows to mitigate liquidity risk effectively.