What is the Defensive Interval Ratio?

What is the Defensive Interval Ratio?

The defensive interval ratio (DIR), also called the defensive interval period (DIP) or basic defense interval (BDI), is a financial metric that indicates the number of days that 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.

Sources of capital include long-term assets such as a company’s patents or PP&E investments, which have relatively poor liquidity. This means they might take considerably more time to sell off at their fair market value.

Typically, long-term assets cannot be sold in the current accounting period. They usually take upwards of one year to liquidate. Examples of long-term, less liquid capital include a company’s external sources of capital that would require time to see cash flows from (e.g., issuing new debt or equity).

A key difference between the defensive interval ratio and other ratios is that the DIR does not compare the company’s current assets to current liabilities. Rather, it compares the company’s current assets to the company’s daily cash expenditures.

As a result, many analysts believe that it is a better ratio to utilize when assessing the liquidity of a specific company. The ratio is labeled “defensive” since it incorporates the company’s current assets, which are also called defensive assets.

introduction of Defensive Interval Ratio (DIR)

The DIR is considered by some market analysts to be a more useful liquidity ratio than the standard quick ratio or current ratio due to the fact that it compares assets to expenses rather than comparing assets to liabilities.

The DIR is commonly used as a supplementary financial analysis ratio, along with the current or quick ratio, to evaluate a company’s financial health, since there can be substantially different DIR and quick or current ratio values if, for example, a company has a large number of expenses but little or no debt.

The DIR is called the defensive interval ratio because its calculation involves a company’s current assets, which are also known as defensive assets. Defensive assets consist of cash, cash equivalents, such as bonds or other investments, and other assets that can readily be converted to cash such as accounts receivables.

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For example, if a company has $100,000 cash on hand, $50,000 worth of marketable securities, and $50,000 in accounts receivables, it has a total of $200,000 in defensive assets. If the company’s daily operational expenses equal $5,000, the DIR value is 40 days: 200,000 / 5,000.

Of course, a higher DIR number is considered good, as not only does it show that a company can rely on its own finances, but it also provides a company with enough time to evaluate other meaningful options in paying its expenses. That being said, there is no specific number that is considered the best or right number for a DIR. It is often worth comparing the DIR of different companies in the same industry to get an idea of what is appropriate, which would also help determine which companies could be better investments.

How to Calculate the Defensive Interval Ratio

The defensive interval ratio is calculated by dividing the company’s current assets by its daily expenditures, as indicated below:

Defensive interval measure = Total defensive assets / Projected daily operating expenditure

Where:

Current Assets = Cash + Accounts Receivable + Marketable Securities

Daily Expenditures = (Annual Operating Expenses – Non-cash Charges) / 365

Many analysts believe that the DIR is a better liquidity ratio to use than the classic quick ratio or current ratio. This is because the DIR measures a company’s short-term liquidity in regard to its daily expenditures.

Also, the DIR provides analysts with a number of days, rather than a ratio of the company’s assets to liabilities. This makes it easier to interpret as a measure of liquidity. Knowing that a company can remain liquid for “X” number of days without tapping into its long-term assets is an easily grasped point of reference.

It provides a clearer, more definitive point of information than, for example, the knowledge that a company has a quick ratio that is greater than one.

That being said, the defensive interval ratio, by itself, does not provide significant context about the company’s situation.

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The ratio should be compared to the DIR of comparable companies in the same industry in order to gain insight into the company’s relative performance. The DIR can also be compared to the company’s own historical DIR to see the liquidity trend over time.

Interpretation of Defensive Interval Ratio

While interpreting the result you get out of the DIR calculation, here’s what you should consider going forward –

  • Even if Defensive Interval Ratio (DIR) is the most accurate liquidity ratio you would ever find, there is one thing that DIR is not noting. If, as an investor, you are looking at DIR to judge the company’s liquidity, it would be important to know that DIR doesn’t consider the financial difficulty the company faces over the period.

Thus, even if the liquid assets are enough to pay off the expenses, it doesn’t mean the company is always in a good position. As an investor, you need to look deeper to know more.

  • While computing the average daily expenses, you should also consider the cost of goods sold as part of the expenses. Many investors don’t include it as part of the average daily expense, which ushers in a different resultant figure than the accurate one.
  • If the DIR is more in terms of days, it is considered healthy for the company, and if the DIR is less, it needs to improve its liquidity.
  • The best way to find out liquidity about a company may not be a Defensive Interval Ratio. Because in any company, every day the expenditure is not similar. It may so happen that there are no expenses in the company for a few days, and suddenly one day, the company can incur a huge expense, and then for a while, there would be no expense again.

So to find out the average, we need to even out the expenses for all the days, even if there are no expenses incurred. The ideal thing to do is to note every expense per day andfind out a trend function where these expenses are repeatedly incurred. It will help to understand the liquidity scenario of a company.

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Advantages and Disadvantages of Defensive Interval Ratio

Advantages and Disadvantages of DIR are as follows:

Advantages

Some of the advantages of the DIR are:

  • It assesses the liquidity position of a company from the perspective of covering the business operating expenses with readily convertible assets which are not the case with other liquidity ratios like current ratio, quick ratio or cash ratio.
  • Gives a clear estimate of the number of days a company can sustain its operating expense, in case of any financial difficulty, without liquidating its long-term assets.

Disadvantages

Some of the disadvantages of DIR are:

  • It is fairly difficult to decide whether the number of days is good or bad if not compared with other companies in the same industry.
  • It does not take into account the fact that the current assets would not liquidate at their current value during times of distress.

Example of Defensive Interval Ratio

Global Industries is facing a gradual decline in its heavy industries unit. At the same time, the company expecting an advance cash payment from a customer in the next 80 days.

Required: The CEO of Global Industries has asked an analyst to determine the company’s ability to stay operational until the payment is received. Using the following data, complete the analyst’s task:

Cash = $1,400,000

Marketable securities = $3,500,000

Accounts receivable = $5,100,000

Average daily expenditures = $118,500

Solution

To determine how long Global Industries can remain operational, it is necessary to calculate the defensive interval ratio (DIR). This involves applying the following formula:

DIR = (Cash + Marketable securities + Accounts receivable) / Average daily expenditures

= (1,400,000 + 3,500,000 + 5,100,000) / 118,500

= 84 days

The above calculation shows that Global Industries’ DIR is 84 days. In other words, the company’s unit can stay operational for the next 84 days without using its non-current assets.

If the expected payment is received at a time later than 80 days, the unit will need to start using its non-current assets and other financial resources.