What’s it: The defensive interval ratio is a financial ratio to measure how long a company can continue to meet daily expenses using existing liquid assets without obtaining additional financing. We calculate it by adding up liquid defensive assets (current assets) such as cash, cash equivalents, and accounts receivable, and then we compare them with daily cash disbursements.
And a higher ratio is considered better because the company has enough money to cover daily expenses. However, a low ratio does not necessarily lead to a liquidity crisis if the company can still cover daily expenses with alternative sources such as liquidating inventory and taking out loans.
Why is the defensive interval ratio important?
The defensive interval ratio is a key metric for evaluating a company’s financial health. It describes the company’s financial liquidity. Specifically, it is useful to understand the money required for the daily operation and know how many days it will last.
Management checks this ratio regularly throughout the operating cycle to determine liquidity conditions. It aims to ensure sufficient cash is available. Such checks are especially important if the company’s sales are seasonal like those in the tourism sector.
Then, this ratio is considered more useful than liquidity ratios such as the current ratio or quick ratio because it uses the actual spending metric as the denominator. In contrast, the liquidity ratio uses current liabilities.
Current liabilities may contain an accrual account. Although it must be settled, it does not contribute to the cashout. An example is an unearned income.
Unearned income represents a liability the company has to settle. This account arises when a company has received payments from customers but, until the financial statements are prepared, has not delivered goods and services to them.
Because settling unearned income does not involve cash outflows, the current liabilities figure also does not reflect the dollars the company has to spend.
How to calculate the defensive interval ratio? What’s the formula?
We need some data to calculate the defensive interval ratio. The first is cash, cash equivalents, or marketable securities and accounts receivable – they are called defensive assets. They are on the balance sheet. We then add them up and use them as the numerator.
Second, we need daily cash disbursements data as the denominator. The data is unavailable on the income statement. We have to estimate it manually by adding the cost of goods sold (COGS) with all operating costs and other cash costs by the number of days in a year (365 days). Remember, we must exclude some non-cash items such as depreciation and amortization from the calculation.
After getting these data, divide the first data by the second data to calculate the defensive interval ratio. Here is the mathematical formula:
- Defensive interval ratio = (Cash + Marketable securities + Accounts receivable) / Daily cash outlay
Now, take a simple example. A company reports cash of $400, marketable securities of $500, and accounts receivable of $100. Meanwhile, the company’s daily operating expenses are $50.
From this example, we get a defensive interval ratio of 20 = ($400+$500+$100)/50. That shows the company’s defensive assets could cover daily cash disbursements for 20 days.
How to interpret the defensive interval ratio?
The defensive interval ratio shows how sufficient the company’s defensive assets are to cover daily expenses. A higher ratio is desirable because it indicates greater liquidity. As a result, the company is able to pay daily expenses and bills without relying on external financing such as borrowing from banks.
For example, the ratio rose from 20 to 23. That shows the company could cover expenses for 23 days by relying on cash on hand, disbursing its short-term investments, and collecting accounts receivable from customers much longer than before (20 days).
Conversely, a low ratio indicates less funds are available. And because of that, it’s less desirable.
Does a low ratio signify a liquidity crisis?
Although a low ratio is not preferred, evaluating this ratio must also be done holistically. For example, a low ratio does not necessarily lead to a liquidity crisis. Instead, we have to check whether there will be significant cash inflows shortly to cover expenses or not.
The cash inflows can come from various sources. First, it may come from liquidating inventory. Companies convert inventory into sales to collect cash. And at this point, we should examine how quickly the company converts its inventory to cash and how well it can increase its inventory turnover. For example, because of an urgent need for cash, the company might sell its products for cash instead of credit so it can hold onto the money more quickly.
Second, cash inflows can also come from external financing. It can be through bank loans or issuing short-term debt securities such as commercial paper. As long as the company’s financial leverage is still tolerable, borrowing is a reasonable option.
Third, liquidating fixed assets such as vehicles is another source of cash inflows. Nonetheless, the process takes more time to liquidate.
Is a high ratio always good?
A high ratio is not necessarily good. Holding too much liquidity has an opportunity cost. The company may miss the opportunity to use it for investment to generate higher profits in the future.
In addition, the high ratio may be largely contributed by increased receivables. And, the company has to bill it from the customer. It could take longer if the quality deteriorates. For this reason, we should check whether customers have always paid them on time and how many days it takes to collect payments from accounts receivable.
What to read next
- Liquidity Ratio: Examples, Formulas, How to Calculate
- Current Ratio: How to Calculate and Interpret
- Quick Ratio: Formula, Calculation, Interpretation
- Cash Ratio: Formula, Calculation, and Interpretation
- Defensive Interval Ratio: Importance, Calculation, and Interpretation
- Acid Test Ratio: Meaning, Formula, Calculation
- Cash Conversion Cycle: How it Works, Calculation and Interpretation