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DEFENSIVE INTERVAL RATIO (DIR) MEANING
Defensive interval ratio (DIR) is a very useful for measuring company’s liquidity position. It measures company’s ability to finance its daily cash expenses out of its liquid assets. In simple language, it estimates the number of days a company can survive its day to day operations with its liquid assets. As long as the company can survive on liquid assets for paying cash expenses, it will not have to depend on fixed assets or external sources of finance.
DEFENSIVE INTERVAL RATIO (DIR) FORMULA
|Defensive Interval Ratio||=|| Liquid Assets
|Estimated Daily Cash Requirements|
Liquid assets are also known as the quick current asset, which is also used in quick ratio. Current assets include some illiquid assets like inventory and prepaid expenses. Including these illiquid assets into calculation will not provide a perfect picture of company’s liquidity. Hence, DIR only includes assets with high liquidity. Liquid assets include:
- Marketable Securities
- Account Receivables
Estimated Daily Cash Requirements
It can be calculated by firstly estimating the annual cash operating expenses and dividing it with 365. Annual cash operating expenses do not include non-cash charges like depreciation. They can be estimated by looking at the past pattern. It is a common practice to take the average of last few year’s cash operating expense as an estimate the next year.
INTERPRETATION AND USES OF DEFENSIVE INTERVAL RATIO (DIR)
|Marketable Securities||$ 200,000|
|Account Receivables||$ 300,000|
|Liquid Assets….(A)||$ 1,400,000|
|Annual Cash Operating Expense…(B)||$ 7,300,000|
|Estimated Daily Cash Requirements…(C)
|Defensive Interval Ratio = (A)/(C)||70 Days|
|Description||Defensive Interval Ratio|
|Company Y||55 Days|
|Industry Average||90 Days|
Company X has defensive interval ratio of 70 days. It means that Company X will have sufficient fund through liquid assets to pay its cash expenses for 70 days. The higher the DIR, the better the liquidity of the firm. High DIR is a positive signal because the company is able to take care of its cash requirements from the internal sources. It creates a buffer period for the company as arranging funds through other sources will be time-consuming.
There is nothing like an ideal number for DIR. It changes from industry to industry. Analysts use it in comparative analysis. A company’s DIR is compared with another company of similar nature and industry average. In the above example, Company X is considered to be better than Company Y because Company X has DIR of 70 days compared to Company Y’s DIR of 55 days. Company X’s DIR is lower compared to industry average, which is a matter of concern. Company X will have to accelerate the cash inflows or arrange other sources of cash. DIR is also used internally by the company itself. The company compares past DIR with recent DIR to gauge an idea about its liquidity position. If DIR is increasing than liquidity is improving and vice versa. Some cyclical industries have a higher requirement of cash during some specific period. DIR can be useful for such industries. It helps in planning the sources from which the capital requirements will be taken care of after liquid assets are fully utilized.
ISSUES WITH DEFENSIVE INTERVAL RATIO
There are some issues with the defensive interval ratio. The estimating the cash required on daily basis is a complex task. Some days a company might require a large amount of cash i.e. large payment to suppliers or employees. Some days the amount of cash required is not so significant. This irregularity makes DIR less accurate measure.
Also, the data used for calculating liquid assets is affected by many other factors. Cash and account receivable keep changing with new transactions throughout the year. Hence, this ratio should be used cautiously otherwise it might not reflect the economic reality of the company.