Wednesday, November 2, 2011

Cash Flow And Balance Sheet Management: Part 1

It may not be an elephant in the room, but it’s bigger than a bread basket.

Income and expenses are flows. Assets and liabilities are stocks. They relate, but aren’t the same. Income and expenses relate to consumption. Wealth only relates to potential consumption when it is translated into income (or expense in the case of liabilities that exceed assets). People who confuse income with wealth are ignoring the difference and not recognizing the cost associated with getting from one to the other.

There are many ways to try to equate one to the other. Market-to-market is one. Just assume perfect markets for assets and, voila, wealth equals market value. It shouldn’t be surprising that The Hedged Economist sees some problems with that approach. Numerous postings on this blog have highlighted the foolishness of the instantaneous liquidity assumption implicit in the perfect market assumption. It has been addressed directly, in terms of the consequences of changes in liquidity, and in discussions of approaches to managing one’s own liquidity needs. However, it’s only one approach, and it is a useful tool.

Another approach, often used as a retirement planning tool, is simulations, Monte Carlo being the most common. It, too, has limitations. Constructed simulations, with explicit assumptions and coefficients, share some of those limitations, but have their own set of problems. They too are useful tools.

An intriguing alternative is market-to-cash or liquidation value. It does try to envision the income the wealth would represent if converted to cash. The obvious problem is that the conversion period is arbitrary (e.g., this week, this year, the length of a bankruptcy proceeding?). The value under mark-to-cash is dependent on the time frame. The reason is mark-to-cash forces an estimate of the liquidity available. The estimate of liquidity is just that, an estimate or guess. Yet, it’s another tool.

One can use the price of an asset with a benchmark income stream. Treasury bills and treasury bonds are used extensively in financial economics as a benchmark return. They present some problems since their prices are volatile and subject to numerous risks. Theoretically, if the comparisons are instantaneous, they would yield what appear to be reliable relative comparisons. But, in fact the relative comparisons are totally dependent on how risk is being priced. An alternative benchmark income stream is to annuitize the wealth. This is another approach.

Each of these approaches yields its own estimate of the relationship between the stock (wealth) and the flow (income). Given the uncertainty associated with measuring the relationship, it is advisable to manage that relationship carefully. It makes sense to take steps to ensure that the management of each is as robust as possible. Also, it is dangerous to make too much dependent on getting the estimate of the relationship exactly right. As in everything, provide for mistakes. They’re guaranteed.

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