What is Asset/Liability Management
Asset/liability management is the process of managing the use of assets and cash flows to meet a company's obligations in order to reduce the firm’s risk of loss from not paying a liability on time. If assets and liabilities are properly handled, the business can increase profits. The asset/liability management process is typically 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 as they come due, and when the assets or earnings can be converted into cash. The asset/liability management 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, given that a bank must pay interest on deposits, and also charges a rate of interest on loans. To manage these two variables, bankers track the net interest margin, or the difference between the interest paid on deposits and interest earned on 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. 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 used in managing assets and liabilities is the asset coverage ratio which computes the value of assets available to pay a firm’s debts. The ratio is calculated as:
Asset Coverage Ratio = [(BV Total Assets - Intangible Assets) – (Current Liabilities - ST Debt Obligations)] / Total Debt Outstanding
where BV is short for book value, and ST is short term.
Tangible assets, such as equipment and machinery, are stated at their 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 a good or poor ratio is, since calculations vary by industry.