What Is Asset/Liability Management?
You know that businesses often deal with debt and liabilities, and you have to manage them to avoid losing capital from late payments. This is where asset/liability management, or ALM, comes in—I see it as the process where your firm develops plans to use assets and cash flows to handle those risks.
When you manage assets and liabilities well, it boosts your business profits. Typically, I apply this to bank loan portfolios and pension plans, and it can even touch on the economic value of equity.
Key Takeaways
- Asset/liability management reduces the risk that a company may not meet its obligations in the future.
- The success of bank loan portfolios and pension plans depends on asset/liability management processes.
- Banks track the difference between the interest paid on deposits and interest earned on loans to ensure that they can pay interest on deposits and to determine the rate of interest to charge on loans.
Understanding Asset/Liability Management
The core of asset/liability management is about timing your cash flows—managers like you must plan for paying liabilities. You need to ensure assets are ready to cover debts as they due, and that earnings or assets can turn into cash quickly. This applies across different asset categories on your balance sheet.
Remember, a mismatch between assets and liabilities can happen due to illiquidity or interest rate changes; ALM cuts down that likelihood.
Factoring in Defined Benefit Pension Plans
With a defined benefit pension plan, you provide employees a fixed benefit at retirement, and you as the employer bear the risk if plan investments fall short. You have to forecast the assets needed to cover those benefits.
For instance, if employees are due $1.5 million in payments starting in 10 years, you estimate the return on investments and figure out annual contributions before payments begin.
Examples of Interest Rate Risk
In banking, ALM manages interest on deposits and loans. You track the net interest margin—the gap between interest paid out and earned.
Say a bank earns 6% on three-year loans and pays 4% on three-year CDs; the margin is 2%. But with interest rate risk, if rates rise, depositors want more, so you must manage to keep assets in the bank.
The Asset Coverage Ratio
A key tool in ALM is the asset coverage ratio, which figures out assets available to pay debts. The formula is: Asset Coverage Ratio = [(BVTA - IA) - (CL - STDO)] / Total Debt Outstanding, where BVTA is book value of total assets, IA is intangible assets, CL is current liabilities, and STDO is short-term debt obligations.
You state tangible assets like equipment at book value—cost minus depreciation. Exclude intangibles like patents because they're hard to value or sell. Short-term debts under 12 months are also out. This ratio shows assets for debt obligations, though liquidating things like real estate can be tricky. No universal good or bad ratio—it varies by industry.
Fast Fact
Asset/liability management is a long-term strategy to manage risks. For example, as a homeowner, you ensure you have enough money to pay your mortgage each month by managing income and expenses over the loan's life.
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