What is 'Asset/Liability Management'
Asset/liability management is the process of managing the use of assets and cash flows to meet company obligations, which reduces the firm’s risk of loss due to not paying a liability on time. If assets and liabilities are properly handled, the business can increase profits. This management process is used for bank loan portfolios and pension plans.
BREAKING DOWN 'Asset/Liability Management'The concept of asset/liability management focuses on the timing of cash flows, because company managers need to know when liabilities must be paid. It is also concerned with the availability of assets to pay the liabilities, and when the assets or earnings can be converted into cash. This process can be applied to different categories of assets on the balance sheet.
Factoring in Defined Benefit Pension Plans
A defined benefit pension plan provides a fixed, pre-established pension benefit for employees upon retirement, and the employer carries the risk that assets invested in the pension plan may not be sufficient to pay all benefits. Companies must forecast the dollar amount of assets available to pay benefits required by a defined benefit plan. Assume, for example, 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 each year before the first payments begin in 10 years.
Examples of Interest Rate Risk
Asset/liability management is also used in banking, since a bank must pay interest on deposits, and it charges a rate of interest on loans. To manage these two variables, bankers track the net interest margin, or the difference between the interest on deposits and loans. Assume, for example, that a bank earns an average rate of 6% on three-year loans and pays a 4% rate on three-year certificates of deposit, which generates an interest rate margin of 2%. Banks are subject to interest rate risk, or the risk that interest rates increase and deposit customers demand higher interest rates to keep assets at the bank.
How the Asset Coverage Ratio Works
The asset coverage ratio computes the amount of available assets to pay a firm’s debts, and this ratio is important for asset/liability management. The formula is:
Tangible assets, such as equipment and machinery, are stated at book value, which is the cost of the asset less accumulated depreciation. Intangible assets, such as patents, are subtracted from the formula, because these assets are more difficult to value and sell. Debts payable in less than 12 months are considered short-term debt, and those liabilities are also subtracted from the formula. The coverage ratio computes the assets available to pay debt obligations, although the liquidation value of some assets, such as real estate, may be difficult to calculate. There is no rule of thumb for what is a good or poor ratio, since calculations vary by industry.