What is Defensive Interval Ratio?
Defensive interval ratio (DIR) is a financial metric that measures how many days a company can operate without needing to access noncurrent assets, long-term assets whose full value cannot be obtained within the current accounting year, or additional outside financial resources. Alternatively, this can be viewed as how long a company can operate while relying only on liquid assets, such as cash, marketable securities, and accounts receivable.
DIR is considered a liquidity ratio, as it indicates the ability of a company to meet its short-term obligations with its current assets. It is also a financial efficiency ratio, as it shows how well a company manages its working capital. A higher DIR means that a company has more liquid assets to cover its daily expenses, and thus has more financial flexibility and stability. A lower DIR means that a company has less liquid buffer and may face liquidity problems if it cannot generate enough cash flow or access other sources of financing.
How to Calculate Defensive Interval Ratio?
The formula for calculating DIR is:
where
- Current assets = Cash + Marketable securities + Net receivables
- Daily operational expenses = (Annual operating expenses – Depreciation and amortization) / 365
To calculate DIR in Excel, we need to enter the values of current assets and daily operational expenses in separate cells, and then use the following formula in another cell:
=current_assets/daily_operational_expenses
Example of Defensive Interval Ratio Calculation
Let us take an example of a company that has the following financial data for the year 2023:
- Cash = $50,000
- Marketable securities = $100,000
- Net receivables = $150,000
- Annual operating expenses = $500,000
- Depreciation and amortization = $50,000
We can calculate the DIR of this company as follows:
- Current assets = Cash + Marketable securities + Net receivables
- Current assets = $50,000 + $100,000 + $150,000
- Current assets = $300,000
- Daily operational expenses = (Annual operating expenses – Depreciation and amortization) / 365
- Daily operational expenses = ($500,000 – $50,000) / 365
- Daily operational expenses = $1,232.88
Using the Excel formula, we get:
=300000/1232.88
The result is:
243.42
This means that the company can operate for 243.42 days, or about 8 months, without needing to access noncurrent assets or outside financial resources.
Interpretation and Analysis of Defensive Interval Ratio
The DIR of a company can be compared with its industry average, its peers, or its historical trend to assess its liquidity position and performance. Generally, a higher DIR is preferred, as it indicates that a company has more liquid assets to cover its daily expenses, and thus has more financial flexibility and stability. However, there is no specific number that is considered the best or optimal for a DIR, as it may vary depending on the nature and cycle of the business, the industry norms, and the company’s strategy and goals. For example, a company that operates in a seasonal or cyclical industry may have a lower DIR during the off-peak periods, but a higher DIR during the peak periods, to match its cash inflows and outflows. A company that has a high growth potential may have a lower DIR, as it invests its cash in expanding its operations and market share, rather than holding it idle. A company that has a low risk appetite may have a higher DIR, as it maintains a large cash reserve to cope with any unforeseen circumstances or opportunities.
Some of the factors that can affect the DIR of a company are:
- The level and composition of current assets: A higher level and proportion of cash and marketable securities will increase the DIR, as they are the most liquid and readily available assets. A higher level and proportion of net receivables will decrease the DIR, as they depend on the collection period and the creditworthiness of the customers.
- The level and composition of operating expenses: A higher level and proportion of fixed costs, such as rent, salaries, and interest, will decrease the DIR, as they are unavoidable and constant regardless of the sales volume. A higher level and proportion of variable costs, such as raw materials, utilities, and commissions, will increase the DIR, as they vary with the sales volume and can be adjusted accordingly.
- The sales and cash conversion cycle: A higher sales volume and a shorter cash conversion cycle will increase the DIR, as they generate more cash inflows and reduce the need for external financing. A lower sales volume and a longer cash conversion cycle will decrease the DIR, as they reduce the cash inflows and increase the need for external financing.
Other Approaches to Measure Liquidity
Besides DIR, there are other liquidity ratios that can be used to measure the ability of a company to meet its short-term obligations, such as:
- Current ratio: It is calculated by dividing the current assets by the current liabilities. It indicates the extent to which the current assets can cover the current liabilities. A current ratio of 1 or more is considered satisfactory, as it means that the current assets are equal to or more than the current liabilities.
- Quick ratio: It is calculated by subtracting the inventory from the current assets, and then dividing the result by the current liabilities. It indicates the extent to which the current assets, excluding the inventory, can cover the current liabilities. A quick ratio of 1 or more is considered satisfactory, as it means that the current assets, excluding the inventory, are equal to or more than the current liabilities.
- Cash ratio: It is calculated by adding the cash and the marketable securities, and then dividing the result by the current liabilities. It indicates the extent to which the most liquid assets can cover the current liabilities. A cash ratio of 1 or more is considered satisfactory, as it means that the most liquid assets are equal to or more than the current liabilities.
These liquidity ratios can be used in conjunction with the DIR to get a more comprehensive and nuanced picture of the liquidity position and performance of a company. However, they also have some limitations and drawbacks, such as:
- They are based on the book values of the assets and liabilities, which may not reflect their true market values or realizable values.
- They are static and point-in-time measures, which may not capture the dynamic and fluctuating nature of the cash flows and the business environment.
- They do not consider the quality and composition of the assets and liabilities, such as the age, turnover, and collectability of the receivables, the obsolescence, perishability, and salability of the inventory, and the maturity, interest rate, and covenant of the debt.
- They do not consider the profitability and growth potential of the company, which may affect its ability to generate cash and access external financing.
Therefore, it is important to use these liquidity ratios with caution and in combination with other financial analysis tools, such as the cash flow statement, the income statement, the balance sheet, the financial ratios, and the industry benchmarks, to get a more holistic and accurate assessment of the liquidity position and performance of a company.
