What is Defensive Interval Ratio?
The term “defensive interval ratio” refers to the metric that determines the number of days for which an entity can sustain its business expenses by using its current assets. In other words, the ratio evaluates the capacity of a business to operate without needing to use its non-current assets. It is also known as the “Defensive Interval Period”. The name “defensive” comes from the fact that to cover the expenses the ratio uses current assets which are considered to be defensive assets because they are the most liquid form of assets and can be readily converted to cash.
Many analysts and investors find the metric of defensive interval ratio more useful than other financial efficiency ratios like the current ratio or quick ratio because it is calculated by comparing the current assets to business expenses rather than comparing the current assets to the current liabilities.
Formula
The formula for the defensive interval ratio can be derived by dividing the total current assets of the subject company by its daily operational expenses. Mathematically, it is represented as,
The current assets include cash, marketable securities, accounts receivables, prepaid expenses, etc., while daily operational expenses can be calculated by deducting non-cash expenses form the annual expenses and then divided the result by 365.
Current Assets = Cash + Marketable Securities + Accounts Receivables + Prepaid Expenses etc.
Daily Operational Expenses = (Annual Expenses – Non-Cash Charges) / 365
Examples of Defensive Interval Ratio(With Excel Template)
Let’s take an example to understand the calculation of the Defensive Interval in a better manner.
Example – #1
Let us take the example of John who has invested in a company named ADF Ltd three years ago. Now John wants to evaluate the liquidity position of the company and one of his friends suggested he use a defensive interval ratio. According to the latest annual report of ADF Ltd, the financial information is available. Based on the above-given information, help John calculate the defensive interval ratio for ADF Ltd.
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Solution:
Current Assets is calculated as
Current Assets = Cash + Marketable Securities + Accounts Receivable + Prepaid Expenses
- Current Assets = $500,000 + $2,000,000 + $1,000,000 + $300,000
- Current Assets = $3,800,000
Daily Operational Expenses is calculated as
Daily Operational Expenses = (Annual Expenses – Depreciation & Amortization Expense) / 365
- Daily Operational Expenses = ($46,500,000 – $600,000) / 365
- Daily Operational Expenses = $125,753.42 per day
It is calculated by using the formula given below
Defensive Interval Ratio = Current Assets / Daily Operational Expenses
- DIR = $3,800,000 / $125,753.42 per day
- DIR = 30.218 days
Therefore, the defensive interval ratio of ADF Ltd stood at 30 days during the last financial year which indicates that the company’s current assets will be able to support its operating expenses for 30 days.
Example – #2
Let us take the example of Apple Inc. to understand the concept of the defensive interval ratio in the case of the real-life company. According to the annual report for the year ended on September 29, 2018, the financial information for 2018 is available. Calculate the defensive interval ratio for Apple Inc. for the year 2018.
Solution:
Current Assets is calculated as
Current Assets = Cash and Cash Equivalents + Marketable Securities + Net Accounts Receivable + Inventories + Vendor Non-Trade Receivables + Other Current Assets
- Current Assets = $25,913 Mn + $40,388 Mn + $23,186 Mn + $3,956 Mn + $25,809 Mn + $12,087 Mn
- Current Assets = $131,339 Mn
Annual Expenses is calculated as
Annual Expenses = Cost of Sales + Research and Development + Selling, General and Administrative
- Annual Expenses = $163,756 Mn + $14,236 Mn + $16,705 Mn
- Annual Expenses = $194,697 Mn
Daily Operational Expenses is calculated as
Daily Operational Expenses = (Annual Expenses – Depreciation & Amortization Expense) / 365
- Daily Operational Expenses = ($194,697 Mn – $10,903 Mn) / 365
- Daily Operational Expenses = $503.55 Mn per day
Defensive Interval Ratio is calculated by using the formula given below
Defensive Interval Ratio = Current Assets / Daily Operational Expenses
- DIR = $131,339 Mn / $503.55 Mn per day
- DIR= 260.83 days
Therefore, the defensive interval ratio of Apple Inc. stood at 261 days during 2018 which indicates a very comfortable liquidity position of the company.
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Advantages and Disadvantages of Defensive Interval Ratio
Advantages and Disadvantages of DIR are as follows:
Advantages
Some of the advantages of the DIR are:
- It assesses the liquidity position of a company from the perspective of covering the business operating expenses with readily convertible assets which are not the case with other liquidity ratios like current ratio, quick ratio or cash ratio.
- Gives a clear estimate of the number of days a company can sustain its operating expense, in case of any financial difficulty, without liquidating its long-term assets.
Disadvantages
Some of the disadvantages of DIR are:
- It is fairly difficult to decide whether the number of days is good or bad if not compared with other companies in the same industry.
- It does not take into account the fact that the current assets would not liquidate at their current value during times of distress.
Conclusion
So, it can be seen that the defensive interval ratio is a very useful ratio that companies use to assess their liquidity position. However, it should be compared with companies in the same industry to derive any meaningful insight.
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