What is the Defensive Interval Ratio?

For example, suppose ABC Company has a DIR of 45 days. That means ABC Company can operate for 45 days without touching the noncurrent assets or long terms assets, or any other financial resources. Many call this ratio a financial efficiency ratioEfficiency RatioEfficiency ratios are a measure of how effectively a company manages its assets and liabilities and include formulas like asset turnover, inventory turnover, receivables turnover, and accounts payable turnover.read more, but it is commonly considered a “liquidity ratio.”

Let us look at the above chart. Apple has a Defensive interval ratio of 4.048 Years, while Walmarts Ratio is 0.579 years. Why is there such a big difference between the two? Does this mean that Apple is better placed from the liquidity point of view?

This ratio is a variation of quick ratioQuick RatioThe quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company, then dividing it by its total current liabilities.read more. As an investor, you need to glance at the DIR of a company for a long period. Through DIR, the company and its stakeholders get to know for many days it can use its liquid assets to pay its bills. If it’s gradually increasing, the company can generate more liquid assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company’s balance sheet.read more to pay for day-to-day activities. And if it’s gradually declining, that means the buffer of the company’s liquid assets is gradually declining too.

To calculate Defensive Interval Ratio (DIR), all we need to do is take out the liquid assets (easily convertible into cash) and then divide it by average expenditure per day. In the denominator, we cannot include every average expense as that may not be used in day-to-day activities. And on the numerator, we can only put items that are easily convertible in cash in the short term.

In simple terms, go to the balance sheet. Look at the current assets. Select the items that can easily convert into cash. Add them up. And then divide it by the average daily expenditure.

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Defensive Interval Ratio Formula

Here’s the formula –

Defensive Interval Ratio (DIR) = Current Assets / Average Daily Expenditures

Now the question is what we would include in the current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more.

We need to take only those easily converted into cash or equivalent items. There are three things we would generally include in the numerator –

Current Assets (that can be converted into liquidity easily) = Cash + Marketable Securities + Trade Accounts Receivable

Other Liquidity Ratios Related articles – Current RatioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it’ short-term loans within a year. Current ratio = current assets/current liabilities read more, Cash RatioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.read more, Current Ratio, and Quick Ratio

We have included these three because they can be easily converted into cash.

Also, check out these articles on Current Assets – Cash & Cash Equivalents, Marketable SecuritiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company’s balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it.read more, Accounts ReceivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more.

Now let’s look at the denominator.

The easy way to find average daily expenditures is to note the costs of goods sold and annual operating expenses. Then we need to deduct any non-cash charges likedepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more, amortization, etc. Then finally, we will divide the figure by 365 days to get the average daily expenditures.

Average Daily Expenditures = (Cost of Goods Sold + Annual Operating Expenses – Noncash Charges) / 365

The defensive Interval Ratio is considered the best liquidity ratio by many financial analysts. Most of the liquidity ratios like the quick ratio current ratio assess the current assets with current liabilities. And thus, they are unable to produce an accurate result about liquidity. In the case of this ratio, the current assets are not compared to current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They’re usually salaries payable, expense payable, short term loans etc.read more; rather, they are compared to expenses. Thus, DIR can produce almost an accurate result of the company’s liquidity position.

But there are a few limitations, which we will discuss at the end of this article. So the idea is to calculate DIR along with the quick and current ratios. It will give the investor a holistic picture of how a company is doing in terms of liquidity. For example, if Company MNC has huge expenses and almost no liabilities whatsoever, the DIR value would be drastically different from the quick ratio or current ratio.

Interpretation

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 functionFind Out A Trend FunctionTrend function calculates the predictive values of Y for given array values of X and uses the least square method based on the given two data series. It returns numbers in a linear trend.read more where these expenses are repeatedly incurred. It will help to understand the liquidity scenario of a company.

Defensive Interval Ratio Example

We will look at a few examples to understand DIR from all angles. Let’s get started with the first example.

Example # 1

Mr. A has been investing in businesses for a while. He wants to understand how Company P is doing in terms of liquidity. So he looks at Company P’s financial statements and discovers the following information –

Particulars of P Company at the end of 2016

How would he find almost an accurate picture of Company P’s liquidity?

It is a simple example. Here we need to calculate Defensive Interval Ratio (DIR) by applying the formula straight since all the information is already given.

The formula of DIR is –

Current Assets include –

Let’s calculate the DIR now –

After the calculation, Mr. A finds that the liquidity position of Company P is not good enough, and he decides to look into other aspects of the company.

Example # 2

Mr. B isn’t able to find the Balance Sheet of Company M., But he has the following information available with him –

Mr. B needs to find the current assets of Company M, which are easily convertible into cash.

We will start by computing the average daily expenditure.

Average Daily Expenditures = (Cost of Goods Sold + Annual Operating Expenses – Non-cash Charges) / 365

So, let’s calculate using the given information –

Now we will use the formula of DIR to find out the current assets, which can easily convert into cash.

Now Mr. B has got to know how much current assets of Company M can be converted into cash in the short term.

Example # 3

Mr. C wants to compare the three companies’ liquidity positions. He has furnished below the following information to his financial analyst to come to the right conclusion. Let’s have a look at the details below –

The financial analyst needs to determine which company is better positioned to pay off the bills without touching any long-term assets or external financial resources.

This example is a comparison between which company is in a better position.

Let’s get started.

Now we will calculate the annual daily expenditure.

Now we can calculate the ratio and determine which company has a better liquidity position.

*Note: These are hypothetical situations and are only used to illustrate DIR.

From the above computation, it’s clear that Co. M has the most lucrative liquidity position among all three.

Colgate Example

Let us calculate the Defensive Interval Ratio for Colgate.

Step 1 – Calculate Current Assets that can convert into cash easily.

  • Current Assets (that can be converted into cash easily) = Cash + Marketable Securities + Trade Accounts ReceivableColgate’s Current Assets contain Cash & Cash Equivalents, Accounts Receivables, Inventories, and Other current assets.Only two items out of these four can be readily converted to cash – a) Cash and Cash Equivalents b) Receivables.

source: Colgate 10K Filings

  • Colgate Current Assets (that can be converted to cash easily) = $1,315 + 1,411 = $2,726 million

Step 2 – Find the Average Daily Expenditures

To find the average daily expenditure, we can use the following formula.

Average Daily Expenditures = (Cost of Goods Sold + Annual Operating Expenses – Non Cash Charges) / 365.

It is a bit tricky here as we are not spoon-fed with all the necessary information.

  • From the Income StatementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more, we get the two items a) Cost of Sales b) Selling General and Administrative Expenses. Another expense is not operating expense and hence excluded from the expenditure calculations.Also, the Venezuela accounting is not an operating expense and is excluded.

To find the non-cash, we need to scan the annual reportAnnual ReportAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company’s performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements.read more of Colgate.

There are two types of non-cash items included in the Cost of Sales or Selling General & Admin expense.

  • Depreciation and Amortization is a non-cash expenses. As per Colgate’s filings, Depreciation attributable to manufacturing operations is included in Cost of salesIncluded In Cost Of SalesThe costs directly attributable to the production of the goods that are sold in the firm or organization are referred to as the cost of sales.read more.The remaining depreciation component is included in Selling, general and administrative expenses.The total Depreciation and Amortization figures are provided in the cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more.

  • Depreciation and Amortization (2016) = $443 million.

  • Colgate recognizes the cost of employee services received in exchange for awards of equity instruments, such as stock options and restricted stock unitsRestricted Stock UnitsRestricted Stock Units or RSU can be defined as stock-based compensation that is issued as company’s stock to an employee. The company establishes vesting requirements based on the performance of an individual and the length of the employment.read more, based on the fair valueFair ValueThe fair value of an investment is the asset sale price that is agreeable to both the buyer and the seller. There is a caveat; the amount should be agreeable in a free trade scenario; there should be no external pressure or conditions.read more of those awards at the grant date over the requisite service period.These are called Stock-Based Compensation. In Colgate, Stock-based compensation expense is recorded within Sel.

Defensive Interval Ratio Video

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