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 asset/liabilities management helps make an additional business profit. This strategic approach of financial management is used in various organizations for managing or minimizing the risk factor in the business.
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Asset Liability Management Explained
Asset liability management process is an important concept used in various industries, primarily in the banking and insurance industry. For example, an effective asset management policy framework can increase banks’ 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. 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 is that companies should have adequate assets to pay off their liabilities. Asset liability management is a systematic approach that can protect against the risks arising from the asset-liability mismatch.
Its objective is to manage risk, not to eliminate risk. It is the process of deciding to control risks and stabilizing the system by balancing assets and liabilities. Companies should have adequate assets to pay off their liabilities whenever due.
Companies can use the Gap analysisGap AnalysisIn Gap Analysis, the actual performance of a company is compared to the desired goals. and Asset Coverage Ratio to quantify this management. In the banking industry, it addresses the risk of asset-liability mismatch because of either interest rate or liquidity risk.
Thus, the concept of asset liability management process has the objective to ensure that the assets and the liabilities of the enterprise are properly matched with each other with relation to the timing, amount and the fluctuations in the interest rate. This will help in controlling the mismatches and lead to optimum use of resources and highest level of financial performance.
1) Gap Analysis in Asset and Liability
A gap is defined as the difference between rate-sensitive assets and rate-sensitive liabilities.
GAP = Rate Sensitive Asset – Rate Sensitive Liabilities
GAP Ratio = Rate Sensitive Asset/ 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.
Asset Coverage Ratio = ((Total asset- intangible asset) – (current liabilities- short term debt))/total debt
The higher the asset coverage ratio, the more assets the company has to pay off its debt. Companies should at least have this ratio as more than 1.
The following are examples of different industries. Let us try to understand the concept of asset liability management strategies with the help of below mentioned examples.
#1 – Banking Industry
Banks are the financial intermediaryFinancial IntermediaryA financial intermediary refers to a third-party, forming environment for conducting financial transactions between different parties. between their customers and future endeavors. 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. Therefore, banks need to implement strong asset-liability management to ensure net interest income and ensure that they can pay off their 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 they have the funds available to pay off these liabilities at any time.
#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. Therefore, these groups need to ensure that they have funds to meet these liabilities.
The above examples and situations clearly point out the uses of the process in different cases and how effectively it helps in handling as well as keeping a balance between the assets and liabilities to meet the business needs on time,
The primary objective of the process are given below. Let us analyse them in details.
- Risk Management – The process helps the institutions manage the various forms of asset liability management risk like fluctuations in the interest rates or liquidity risk. Interest rates affect the capital and the earnings. It is important to keep track of the changes in the value of assets and liabilities due to interest changes and try to mitigate it. Liquidity risk is another important factor that leads to negative consequences. Adequate liquidity helps in meeting the financial obligations. It is necessary to assess the assets and liabilities tio know that there ae sufficient liquid assets to cover the liabilities.
- Profit optimization – The concept guides the organizations regarding proper use and management of assets and liabilities so that there is least wastage of resources and proper use for profit maximization.
- Capital adequacy – Capital adequacy means assessing the capital requirements of the business and designing methods to maintain them. The business structure should be such that it should be able to maintain the financial stability by arranging for proper capital sources as and when needed.
Thus, it is necessary to keep the above objectives in mind and design ways of managing the asset liability management risk to achieve maximum profit at minimum cost.
Following are the benefits of asset liability management strategies:
- It helps in risk measurement and management for companies. Companies can effectively identify the mismatch in the asset and liabilities and settle the differences or point out the loopholes.
- 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. This will ensure there is always an adequate level of liquid assets that can be used to meet the short term liabilities.
- Effective ALM protects and enhances the profit and net worth of a company. The company can properly use the assets instead of keeping them idle, leading to better resource supply, higher revenue and profits.
- 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 kinds of risks in the company.
- The asset liability management system helps in finalizing the short-term and long-term planning for a company. Proper track and record keeping of assets and liabilities help the business to plan its future expansion and growth prospects as per the available resources.
- It helps in strategizing the introduction of new products in the market.
Below point is the limitation:
- Other criteria need to be looked upon to check the risks of a company apart from asset-liability management. Factors like changes in market conditions, natural disasters, economic and political instability, currency fluctuations, etc, play a very important role in magnifying risks in a business, apart from asset and liability valuation.
- It can be misleading sometimes. It is necessary to be very careful and have proper knowledge and skill for management or tracking of assets and liabilities. If calculations and evaluation is not correct, the business may be mislead.
- Sometimes having risk is better because high risk gives higher returns. The business should have good risk management techniques so that it can be controlled and returns are enhanced.
It is important to identify both benefits and limitations of a financial concept of asset liability management system so that it can be implemented in the business and used to its optimum capacity to achieve maximum results.
This has been a guide to what is Asset Liability Management. We explain its various techniques & objectives along with examples, benefits and limitations. You can learn more about financing from the following articles –