What is asset liability management (ALM)
To understand the ALM meaning, we first need to know what assets and liabilities are. Read the table below:
| Parameters | Assets | Liabilities |
| Meaning | Assets refer to resources owned by an individual or entity.These hold economic value and can be converted into cash. | Liabilities represent financial obligations or debts.These are owed by an individual or entity to others and result in cash outflow |
| Some common examples | StocksBondsReal estate, andCash and cash equivalents | DebenturesBank loansMortgagesCreditors |
Now, with this understanding, consider that asset liability management revolves around strategically managing both assets and liabilities to:
- Optimise financial performance and
- Mitigate liquidation risks
Let us better our understanding by knowing some common objectives of ALM.
Why do companies do asset liability management
1. To match assets and liabilities:
- One of the primary objectives of ALM is to match the maturities, cash flows, and risk profiles of assets and liabilities.
- It aims to synchronise the timing and nature of cash inflows and outflows.
- This synchronisation minimises the business risk of not being able to meet the financial obligations.
2. To maintain liquidity:
- ALM focuses on maintaining adequate liquidity that helps in:
- Fulfilling short-term financial commitments and
- Seizing investment opportunities as they arise
- Additionally, by ensuring sufficient liquidity, businesses avoid forced asset sales at unfavourable prices.
3. To manage interest rate risk:
- ALM is also used to manage interest rate risk.
- Fluctuations in interest rates impact the value of both assets and liabilities.
- To combat these fluctuations, ALM strategies recommend for:
- Diversifying the investments
- Adjusting the duration of assets and liabilities, and
- Employing hedging techniques such as interest rate swaps.
How asset liability management is done
ALM is mostly done by business organisations to identify and remove the cashflow mismatches between assets and liabilities. This process typically involves several steps. Let us understand them in detail:
Step I: Assessment
- Companies identify and analyse their assets and liabilities
- They start compiling a comprehensive inventory of their financial resources, which includes the following:
| Assets | Liabilities |
| Investments Cash reserves Receivables, and Physical assets |
Debts LoansPayables, and Future commitments |
- Post compilation, businesses analyse the characteristics of assets and liabilities in terms of:
- Nature
- Duration
- Cash flows, and
- Associated risks
Step II: Identification
- In this step, companies determine these three key elements related to each asset and liability:
- Maturity profiles
- Interest rate sensitivities, and
- Liquidity needs
- Potential mismatches are identified, which is commonly due to differences in:
- Maturity dates
- Interest rate structures, and
- Currency denominations
Step III: Strategising
- Post identification of potential mismatches, companies formulate a comprehensive ALM strategy.
- It primarily outlines the following actions:
- Take measures to diversify the assets
- Determine the target asset allocation
- Formulate strategies to align assets with liabilities
Important: It must be noted that the ultimate goal of every ALM strategy is to align the maturity and cash flow profiles of their assets with those of their liabilities. This matching ensures that the organisation has sufficient liquidity to meet its short-term obligations while optimising returns on its assets over the long-term.
Step IV: Implementation
- The formulated ALM strategy is usually implemented in three different ways:
| Asset allocation | Portfolio management | Liability management |
| According to the predetermined asset allocation targets, funds are allocated to different asset classes such as:EquitiesFixed-income securitiesReal estate, andCash equivalents | Portfolio management steps are initiated to:Diversify investmentsMinimise risk, andMaximise returns. | The liabilities are matched with assets via:Refinancing debtRestructuring obligations, andManaging repayment schedules to:Reduce interest costs andImprove cash flow |
A hypothetical example of asset liability mismatch
Scenario
ABC Ltd. is a manufacturing company. It has recently expanded its operations and financed the expansion by issuing long-term bonds with fixed interest rates. These bonds have a maturity of 10 years.
Problem
The company's sales have been declining due to changing market conditions and consumer preferences. This decline has led to a decrease in its cash flow and profitability.
Mismatch
- The company faces an asset liability mismatch.
- Its long-term bonds require fixed interest payments over 10 years.
- On the other hand, its declining cash flows are making it challenging to meet these obligations.
- ABC Ltd. faces liquidity risk and cannot generate sufficient cash to service its debt.
Solution
- To address this mismatch, the company evaluates the following options:
- Refinancing its debt
- Extending the maturity of its bonds, or
- Improving its liquidity position through:
- Cost-cutting measures or
- Asset sales
How investors can spot an asset liability mismatch
Investing in companies facing ALM can expose you to the risk of capital losses. By conducting thorough due diligence, you can identify such companies and make informed investment decisions.
Let us see some common factors that will provide you with insights into a company’s financial health and potential ALM:
1. Assess financial statements
- Review a company's financial reports, including its annual reports, quarterly filings, and investor presentations.
- Look for indicators such as:
- High levels of debt
- Mismatched maturity profiles between assets and liabilities, and
- Significant interest rate sensitivity.
2. Analyse the debt profile
- Examine the company's debt profile.
- Specifically, look for:
- Outstanding debt
Maturity dates of debt obligations, and - Interest rate exposure
- Companies with a high level of long-term debt or debt that matures in the near term are more vulnerable to ALM issues.
3.Perform cash flow analysis
- Evaluate the company's cash flow generation capabilities relative to its debt obligations.
- Usually, companies with declining or volatile cash flows struggle to meet their debt obligations.
- For doing this analysis you can analyse these metrics:
- Cash flow from operations
- Free cash flow, and
- Debt service coverage ratios
4. Credit ratings
- Review the company's credit ratings assigned by credit rating agencies such as Moody's, Standard & Poor's, and Fitch.
- Lower credit ratings indicate higher credit risk and suggest potential ALM challenges.
- Also, pay attention to any rating downgrades or negative outlooks, as these signal:
- Deteriorating financial health and
- Increased ALM risk.
Conclusion
ALM full form is asset liability management. It is a technique often used to eliminate the mismatch between the assets and liabilities of a company by aligning the cash inflows with the cash outflows. This alignment is commonly done through several measures such as debt refinancing, altering maturity dates, cost-cutting, asset sales, and much more.
Understanding the ALM is paramount for investors. By avoiding companies gripped with asset liability mismatch that they can enhance portfolio performance, preserve capital, and invest in the financial markets with confidence.
