The Defensive Interval Ratio (DIR): Is Your Liquidity in Dire Straits?

Introduction[i]

Warren Buffett once advised, “Rule No. 1 is never lose money.?Rule No. 2 is never forget Rule No. 1.”?Cash on hand now is certainly better than promises to pay later, especially when trying to keep the business open.?As a result, chief financial officers, creditors, bankers, and analysts rely on several liquidity measures—quick ratio, current ratio, days cash outstanding, days receivables outstanding, days inventory outstanding, but the defensive interval ratio is considered to be one of the most valuable liquidity ratios. Expressly, it focuses on calculating how many days it takes for a company to pay for its operating expenses by utilizing its most liquid assets, without reaching external financing resources.?Therefore, it is a highly valuable tool that assesses a company’s liquidity risk. A company’s capability of surviving on liquid assets displays a strong, powerful business that doesn’t depend on external support to function.

The reason why a company has to monitor this ratio is to diagnose the liquidity situation and how it changes over time. Some firms exist in very cyclical businesses, for example, the tourism industry. Even if some customers might decide to book their holidays early, they typically travel during the holiday seasons. During the booking season, the travel company is likely to be flush with cash. Nevertheless, it still depends on their customers to actually make the trip, so, during this timeframe, revenues will be quite low but still will require the travel firm to cover the costs of its daily operations by drawing on internal sources.

What is the Defensive Interval Ratio (DIR)?[ii]

The defensive interval ratio compares a firm’s liquid assets to its expenditure levels to determine how long a business can keep paying its bills. There is no correct answer to the number of days over which existing assets will provide sufficient funds to support company operations, but more is better than less. ?Instead, review the measurement’s trend over time; if the defensive interval is declining, this is an indicator that the company’s buffer of liquid assets is gradually declining in proportion to its immediate payment obligations.

To calculate the defensive interval ratio, add up the liquid assets on hand--the amounts of cash, marketable securities, and trade accounts receivable on hand-- and then divide by the average amount of daily expenditures. The denominator is not supposed to be the average amount of expenses because the average may exclude any ongoing expenditures made for assets. Also, only put trade accounts receivable in the numerator because other receivables such as from officers of the company or other less-than-arm’s length receivable ?may not be collectible in the short term. The formula is:

(Cash + Marketable Securities + Trade accounts receivable) ÷ Average daily expenditures

However, there are several issues with this calculation that should be considered when evaluating its results—quality of information, expenditure inconsistency, receivable replenishment, and receipt inconsistency:

1-Quality of information.?Valid financial analysis depends on reliable and accurate accounting information, but one of the challenges in evaluating smaller firms and organizations is the quality and frequency of the financial data usually declines as the size of the entity declines.?Lending to small borrowers forces many lenders to rely on annual tax returns often on automatic extension until October 15, and while the returns might confirm reported revenues and profits, they are not a useful source of liquidity data.

2-Expenditure Inconsistency.?The average amount of expenses that a business incurs on a daily basis is just not consistent; in fact, it is very lumpy. For example, there may be no significant expenditure required for several days until, perhaps, a large payroll payment followed by a large payment to a specific supplier. Because of the uneven timing of expenditures, using average expenses does not yield an overly accurate view of exactly how long a company’s assets will support operations.

3-Receivable Replenishment.?The cash and accounts receivable figures used in the numerator are constantly being replenished by new sales, so there is likely to be more cash available from this source than is indicated by the ratio.

4-Receipt Inconsistency.?Cash receipts tend to be just as uneven as expenditures, so the amount of cash available to actually pay for expenditures may not be adequate.

Example of the DIR:?DIRe Straits?

Hummer Industries is suffering through a cyclical decline in the heavy equipment industry, but the cycle appears to be improving again. The company expects a cash-in-advance payment from a major customer in 60 days, but the CFO wants to determine the ability of the company to stay in business at its current rate of expenditure. The following information applies to the analysis:

Cash = $1,200,000

Marketable securities = $3,700,000

Trade receivables = $4,100,000

Average daily expenditures = $138,500

The CFO calculates the defensive interval ratio to be 65 days:

($1,200,000 Cash + $3,700,000 Marketable securities + $4,100,000 Receivables) ÷ $138,500 Average daily expenditures = 65 days

The CFO concludes the company has sufficient cash to remain in operation for 65 days. However, this figure is so close to the projected receipt of cash from the customer and the use of average daily expenditures ignores the lumpiness of expenditures, so the CFO considers that it may make sense to eliminate all discretionary expenses for the next few months to extend the period over which remaining cash can be stretched.?Still, the CFO has a starting point for sharpening the estimate.

Summary and Closing:?Too Much of a Good Thing?

Mark Twain warned, “The lack of money is the root of all evil.”?Evil may just be in the eye of the beholder, but DIR users need to see clearly the pros and cons of their DIR picture.?A higher DIR is considered to be more favorable because it suggests more liquidity.?However, it might also be that a company is not using its capital effectively with too much invested in low-yielding liquid assets.?Then there is the uneven flow of cash receipts and cash expenditures to muddy the liquidity waters.?Nevertheless, DIR is one way to keep an eye on liquidity levels.

[i] “Defensive Interval Ratio,”?Profitco, ?https://www.profit.co/blog/kpis-library/finance/defensive-interval-ratio-dir/

[ii] “Defensive Interval Ratio”, Accounting Tools, https://www.accountingtools.com/articles/defensive-interval-ratio-definition-and-usage.html , July 12, 2022