What Is Asset/Liability Management?
Asset/liability management is the most common way of dealing with the utilization of assets and cash flows to reduce the firm's risk of loss from not paying a liability on time. Very much oversaw assets and liabilities increase business profits. The asset/liability management process is ordinarily applied to bank loan portfolios and pension plans. It additionally includes the economic value of equity.
Figuring out Asset/Liability Management
The concept of asset/liability management centers around the timing of cash flows since company managers must plan for the payment of liabilities. The cycle must guarantee that assets are accessible to pay debts surprisingly and that assets or earnings can be changed over into cash. The asset/liability management process applies to various categories of assets on the balance sheet.
[Important: A company can face a mismatch among assets and liabilities as a result of illiquidity or changes in interest rates; asset/liability management reduces the probability of a mismatch.]
Calculating in Defined Benefit Pension Plans
A defined benefit pension plan gives a fixed, pre-laid out pension benefit for employees upon retirement, and the employer conveys the risk that assets invested in the pension plan may not be adequate to pay all benefits. Companies must forecast the dollar amount of assets accessible to pay benefits required by a defined benefit plan.
Expect, for instance, that a group of employees must receive a total of $1.5 million in pension payments starting in 10 years. The company must estimate a rate of return on the dollars invested in the pension plan and determine how much the firm must contribute every year before the first payments start in quite a while.
Instances of Interest Rate Risk
Asset/liability management is likewise utilized in banking. A bank must pay interest on deposits and furthermore charge a rate of interest on loans. To deal with these two factors, bankers track the net interest margin or the difference between the interest paid on deposits and interest earned on loans.
Expect, for instance, that a bank procures an average rate of 6% on three-year loans and pays a 4% rate on three-year certificates of deposit. The interest rate margin the bank generates is 6% - 4% = 2%. Since banks are subject to interest rate risk, or the risk that interest rates increase, clients demand higher interest rates on their deposits to keep assets at the bank.
The Asset Coverage Ratio
An important ratio utilized in overseeing assets and liabilities is the asset coverage ratio which processes the value of assets accessible to pay a firm's debts. The ratio is calculated as follows:
Unmistakable assets, like equipment and machinery, are stated at their book value, which is the cost of the asset less accumulated depreciation. Immaterial assets, like licenses, are deducted from the formula on the grounds that these assets are more hard to value and sell. Debts payable in under 12 months are viewed as short-term debt, and those liabilities are likewise deducted from the formula.
The coverage ratio registers the assets accessible to pay debt obligations, albeit the liquidation value of certain assets, like real estate, might be hard to ascertain. There is no rule of thumb with regards to what comprises a decent or poor ratio since computations shift by industry.
- Asset/liability management reduces the risk that a company may not meet its obligations in the future.
- The progress of bank loan portfolios and pension plans rely upon asset/liability management processes.
- Banks track the difference between the interest paid on deposits and interest earned on loans to guarantee that they can pay interest on deposits and to determine what a rate of interest to charge on loans.
[Fast Fact: Asset/liability management is a long-term strategy to oversee risks. For instance, a property holder must guarantee that they have sufficient money to pay their mortgage every month by dealing with their income and expenses for the duration of the loan.]