How do you manage your assets and liabilities?

The technique of controlling the use of assets and cash flows to lessen the firm’s risk of loss from failing to pay liabilities on time is known as asset/liability management. Assets and liabilities that are properly handled boost a company’s earnings. Pension plans and bank loan portfolios are two common examples of when the asset/liability management approach is used. The economic worth of equity is also a factor.

Acquiring knowledge about asset and liability management

Because business managers must make plans for the payment of obligations, the asset/liability management approach strongly emphasizes the timing of cash flows. Assets must be accessible to pay debts when they become due, and the procedure must guarantee that assets or profits may be turned into cash. On the balance sheet, many asset types are subject to the asset/liability management process.

Taking Defined Benefit Pension Plans into Account

When an employee retires under a defined benefit pension plan, they will get a fixed, predetermined pension benefit, and the employer assumes the risk that the assets invested in the pension plan won’t be enough to provide all benefits. Forecasting is necessary for businesses to determine how much money will be available to pay benefits under a defined benefit plan.

Consider the scenario where workers must start receiving pension payments in 10 years for $1.5 million. Before the first payments start in ten years, the employer must calculate an estimated rate of return on the money invested in the pension plan and establish how much it needs to contribute annually.

Interest Rate Risk Examples

In banking, asset/liability management is also employed. A bank must charge interest on loans and pay interest on deposits. To control these two factors, bankers monitor the net interest margin or the difference between interest received on loans and interest paid on deposits.

Consider the scenario where a bank earns an average of 6% on loans with a term of three years and pays 4% on certificates of deposit within three years. The bank makes an interest rate margin of 6% – 4% = 2%. Customers seek greater interest rates on their deposits to maintain assets with the bank because banks are vulnerable to interest rate risk or the chance that interest rates may rise.

Equipment and machinery are tangible assets valued at their book value, which is the asset’s original cost less cumulative depreciation. Since intangible assets such as patents are more challenging to value and sell, they are excluded from the calculation. Short-term debt is defined as debt due in less than 12 months, and such obligations are also deducted from the calculation.

Although it could be challenging to determine the liquidation value of some assets, including real estate, the coverage ratio calculates the assets available to meet debt obligations. Since computations differ by industry, there is no general definition of a good or poor ratio.

Conclusion

• Asset and liability management lowers the possibility that a business won’t be able to fulfill its commitments in the future.
• Asset and liability management procedures are essential to the success of pension schemes and bank loan portfolios.
• To ensure they can pay interest on deposits and choose what interest rate to charge on loans, banks keep track of the difference between interest received on loans and interest paid on deposits.