What is Asset Liability Management?
An asset/liability management is the process that is defined as paying off liabilities from assets and cash flows of a company, and its proper implementation reduces the risk of loss for not paying the liabilities on time. Companies must ensure that assets and cash flows are there available on time when needed to avoid additional interest and penalties. Better use of asset/liabilities management helps in making an additional business profit.
Techniques Used for Asset Liability Management
1) Gap Analysis in Asset and Liability
A gap is defined as the difference between Rate sensitive assets and Rate Sensitive liabilities.
2) Asset Coverage Ratio
Another important ratio to manage the asset and liabilities is the asset coverage ratioAsset Coverage RatioAsset Coverage Ratio is a risk analysis multiple that depicts the company’s ability to repay the debt by selling off the assets and outlines how much of the monetary and tangible assets are available against the debt. It helps an investor to predict the future earnings and gauge the risk involved in the investment., which determines the number of assets available to pay off the debts.
The higher the asset coverage ratio, the more asset, the company is having to pay off its debt. Companies should at least have this ratio as more than 1.
Examples of Asset Liability Management in Different Industries
The following are examples of different industries.
#1 – Banking Industry
Banks are the financial intermediary between its customers and future endeavours. Banks take a deposit from their customers for which they are obliged to pay interest. From these deposits, they provide loans for which they receive interest income. Banks need to implement strong asset-liability management to ensure between net interest income and to ensure that it can pay off its customer deposits at any given time.
#2 – Insurance Companies
Insurance companies provide two types of insurance: life and non-life. Non- life insurance is property and vehicle insurance. Insurance companies receive payment from other parties, but they are liable to pay some lump sum amount as and when required. So they will have to make sure that at any time, they are having the funds available to pay off these liabilities.
#3 – Benefit Plan
Benefit Plans such as future retirement plans take some funds out of employees’ salaries and then, in the future, pay this amount with the applicable rate at the time of retirement. These groups need to make sure that they have funds to meet these liabilities.
Following are the benefits:
- It helps in risk measurement and management for companies.
- Effective asset-liability management ensures liquidity riskLiquidity RiskLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases. management.
- Effective ALM protects and enhances the profit and net worth of a company.
- It increases the net interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. of the banking institution.
- ALM is used to quantify the various kind of risks in the company.
- It helps in finalizing the short term and long term planning for a company.
- It helps in strategizing the introduction of new products in the market.
Below point is the limitation:
- There are other criteria which need to be looked upon to check the risks of a company apart from an asset-liability management
- It can be misleading sometimes.
- Sometimes having risk is better because high risk gives higher returns.
Important Points to Note
- Its objective is to manage risk, not to eliminate risk.
- It is the process of taking a decision to control risks and stabilizing the system by balancing assets and liabilities.
- Companies should have adequate assets to pay off its liabilities whenever due.
- Companies can use the Gap analysis and Asset Coverage Ratio to quantify this management.
- In the banking industry, It is used to address the risk of asset-liability mismatch because of either interest rate or liquidity risk.
Asset liability management is an important concept that is being used in various industries, primarily in the banking and insurance industry. An effective asset management policy framework can increase the profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. of banks by increasing net interest income.
A better view can be seen as a coordinated process of combining balance sheet itemsBalance Sheet ItemsAssets such as cash, inventories, accounts receivable, investments, prepaid expenses, and fixed assets; liabilities such as long-term debt, short-term debt, Accounts payable, and so on are all included in the balance sheet. into the right mix. The gist of the technique that companies should have adequate assets to pay off its liabilities Asset liability management is a systematic approach that can provide protection against the risks which can arise from the asset-liability mismatch.
This has been a guide to what is asset-liability management. Here we discuss techniques and examples of industries in asset-liability management along with benefits and limitations. You can learn more about financing from the following articles –