What is Defensive Interval Ratio?
Defensive Interval ratio is the ratio which measures the number of days within which the company can continue its working without the requirement of using its non-current assets or the outside financial resources and it is calculated by dividing the total current assets of the company with its daily operating expenses.
For example, if 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 as 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 as “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 ratio. Through DIR, the company and its stakeholders get to know for many days it can use its liquid assets to pay its bills. As an investor, you need to have a glance at the DIR of a company for a long period of time. If it’s gradually increasing, it means the company is able to 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 liquid assets of the company is gradually declining too.
To calculate Defensive Interval Ratio (DIR), all we need to do is to take out the liquid assets (that are 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 getting used in the 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 be converted into cash. Add them up. And then divide it by the average daily expenditure.
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For eg:
Source: Defensive Interval Ratio (wallstreetmojo.com)
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 items that are easily converted into cash or equivalent. 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 refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.read more.
Now let’s look at the denominator.
The easy way to find out average daily expenditures is to first note the costs of goods sold and annual operating expenses. Then we need to deduct any non-cash charges like depreciation, 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 to be the best liquidity ratio by many financial analysts. Most of the liquidity ratios like 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 is able to produce almost an accurate result of the liquidity position of the company.
But there are few limitations as well, which we will discuss at the end of this article. So the idea is to calculate DIR along with quick ratio and current ratio. 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, then the DIR value would be drastically different than the value of the quick ratio or current ratio.
Interpretation
While interpreting the result you get out of 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 is not being noted by DIR. If, as an investor, you are looking at DIR to judge the liquidity of the company, it would be important to know that DIR doesn’t take into account 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 taking into account 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 than 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 for a few days, there are no expenses in the company, 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 on those days. The ideal thing to do is to take a note of every expense per day and find 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. This will help to understand the liquidity scenario of a company.
Defensive Interval Ratio Example
We will look at a few examples so that we can 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
| Details | 2016 (In US $) |
|---|---|
| Cash | 30,00,000 |
| Trade Receivables | 900,000 |
| Marketable Securities | 21,00,000 |
| Average Daily Expenditure | 200,000 |
How would he find almost an accurate picture of Company P’s liquidity?
This 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 –
Defensive Interval Ratio (DIR) = Current Assets / Average Daily Expenditures
Current Assets include –
Current Assets (that can be converted into liquidity easily) = Cash + Marketable Securities + Trade Accounts Receivable
Let’s calculate the DIR now –
| Details | 2016 (In US $) |
|---|---|
| Cash (1) | 30,00,000 |
| Trade Receivables (2) | 900,000 |
| Marketable Securities (3) | 21,00,000 |
| Current Assets (4 = 1+2+3) | 60,00,000 |
| Average Daily Expenditure (5) | 200,000 |
| Ratio (4/5) | 30 days |
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 –
| Details | 2016 (In US $) |
|---|---|
| Cost of Goods Sold (COGS) | 30,00,000 |
| Operating expenses for the year | 900,000 |
| Depreciation Charges | 100,000 |
| Defensive Interval Ratio | 25 days |
Mr. B needs to find the current assets of Company M, which are easily convertible into cash.
We have been given the information for computing the average daily expenditure, and we know how to calculate the defensive interval ratio. By applying the information given above, we can find out the current assets of Company M, which are easily convertible.
We will start by computing the average daily expenditure.
Here’s the formula –
Average Daily Expenditures = (Cost of Goods Sold + Annual Operating Expenses – Non-cash Charges) / 365
So, let’s calculate using the given information –
| Details | 2016 (In US $) |
|---|---|
| Cost of Goods Sold (COGS) (1) | 30,00,000 |
| Operating expenses for the year (2) | 900,000 |
| Depreciation Charges (3) | 100,000 |
| Total expenses (4 = 1 + 2 – 3) | 38,00,000 |
| Number of days in a year (5) | 365 days |
| Average Daily Expenditure (4/5) | 10,411 |
Now we will use the formula of DIR to find out the current assets which can easily be converted into cash.
| Details | 2016 (In US $) |
|---|---|
| Average Daily Expenditure (A) | 10,411 |
| Defensive Interval Ratio (B) | 25 days |
| Current Assets (C = A * B) | 260,275 |
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 position. 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 –
| Details | Co. M (US $) | Co. N (US $) | Co. P (US $) |
|---|---|---|---|
| Cash | 300,000 | 400,000 | 500,000 |
| Trade Receivables | 90,000 | 100,000 | 120,000 |
| Marketable Securities | 210,000 | 220,000 | 240,000 |
| Cost of Goods Sold | 200,000 | 300,000 | 400,000 |
| Operating Expenses | 100,000 | 90,000 | 110,000 |
| Depreciation Charges | 40,000 | 50,000 | 45,000 |
The financial analyst needs to find out which company is in a better position 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.
| Details | Co. M (US $) | Co. N (US $) | Co. P (US $ |
|---|---|---|---|
| Cash (1) | 300,000 | 400,000 | 500,000 |
| Trade Receivables (2) | 90,000 | 100,000 | 120,000 |
| Marketable Securities (3) | 210,000 | 220,000 | 240,000 |
| Current Assets (4 = 1+2+3) | 600,000 | 720,000 | 860,000 |
Now we will calculate the annual daily expenditure.
Now we can calculate the ratio and find out which company has a better liquidity position.
| Details | Co. M (US $) | Co. N (US $) | Co. P (US $ |
|---|---|---|---|
| Current Assets (1) | 600,000 | 720,000 | 860,000 |
| Average Daily Expenditure (2) | 712 | 932 | 1274 |
| Defensive Interval Ratio (1/2) | 843 days* | 773 days | 675 days |
*Note: All of these are hypothetical situations and 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 be converted into cash easily.
- Current Assets (that can be converted into cash easily) = Cash + Marketable Securities + Trade Accounts Receivable
- Colgate’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
In order to find the average daily expenditure, we can use the following formula.
Average Daily Expenditures = (Cost of Goods Sold + Annual Operating Expenses – Noncash Charges) / 365.
Here it is a bit tricky 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.
- Other expense is not an operating expense and hence excluded from the expenditure calculations.
- Also, the charge for Venezuela accounting in not an operating expense and is excluded.
source: Colgate 10K Filings
In order 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 that are included in the Cost of Sales or Selling General & Admin expense.
2a) Depreciation & Amortization
- Depreciation and Amortization is a non-cash expense. As per Colgate’s filings, Depreciation attributable to manufacturing operations is included in Cost of sales.
- The remaining component of depreciation is included in Selling, general and administrative expenses.
- The total Depreciation and Amortization figures are provided in the cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities.read more.
source: Colgate 10K Filings
- Depreciation and Amortization (2016) = $443 million.
2b) Stock-Based Compensation
- 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 value of those awards at the date of grant over the requisite service period.
- These are called at Stock-Based Compensation. In Colgate, Stock-based compensation expense is recorded within Sel.
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