Defensive interval ratio
Defensive interval ratio (DIR, DIP, BDI) is a metric that describes how long the company can operate without access to noncurrent assets. It is a kind of liquidity index. In the literature it can be found also as:
- defensive interval period,
- basic defense interval.
The noncurrent assets are e.g. those that cannot be obtained in current accounting year. The current assets are:
- cash
- securities that can be sold on market
- net receivables
The longer DIR is the better for liquidity. But too high DIR can indicate that the company doesn't invest in long-term, which can bring problems in future.
How to calculate defensive interval ratio?
The formula for defensive interval ratio is:
If the daily operational expenses cannot be calculated based on current data, they can be predicted: annual operating expenses - noncash charges, all divided by 365 days.
Need and usability Defensive interval ratio
The Cash Safety Period indicator (DIR) is one of the most important indicators of the company's financial liquidity, informing about the company's ability to service its current liabilities. When analyzing economic indicators and their use in current operations, attention should be paid to the need for periodic analysis of indicators - preferably on a monthly basis. In this case, it seems that the application of quarterly periods completely exhausts the cognitive values of this measure and its more frequent use, although possible, seems not to be necessary. The great advantage of DIR, for those less familiar with the theory of finance, is the fact that this index is calculated in days. Because of this he is very suggestive. Calculated for a given company, DIR informs how many days a company can operate thanks to the already possessed liquid assets, without the need to receive funds from the next period. The Management Board, knowing the current value of the DIR and the emerging trend, and having its own preferences as to its expected value, is in a comfortable situation, able to act on this basis to stabilize the DIR at the correct (expected) level.
The result from the above equation shows theoretically that a company can operate without the inflow of cash to the indicated number of days. It is difficult to judge if the result is good or bad. In order for such an assessment to become possible, more information is needed. First of all, it is good to know the trend of the indicator from calculations for earlier periods. Secondly, the management should have its own expectations in this respect and refer them to current calculations. Thirdly, it would be great to know the estimated value of DIR for the industry in which the company specializes in its area of influence.
The defensive interval ratio the most important things which can indicator able to indicate in statistical terms the method of measuring liquidity and indebtedness in an enterprise. (Blanchette M. 2012, p. 6-26).
Examples of Defensive interval ratio
- Days Inventory Outstanding (DIO): This is the average number of days it takes the company to sell its inventory. It is calculated by dividing the average inventory on hand by the cost of goods sold, then multiplying by the number of days in a period (usually, a year).
- Days Payable Outstanding (DPO): This is the average number of days it takes the company to pay its suppliers for goods and services. It is calculated by dividing the average accounts payable on hand by the cost of goods sold, then multiplying by the number of days in a period (usually, a year).
- Days Sales Outstanding (DSO): This is the average number of days it takes the company to collect its receivables. It is calculated by dividing the average accounts receivable on hand by the cost of goods sold, then multiplying by the number of days in a period (usually, a year).
- Cash Conversion Cycle (CCC): This is the average number of days it takes the company to receive cash from its operations. It is calculated by subtracting the DPO from the DIO and adding the DSO.
Advantages of Defensive interval ratio
The Defensive interval ratio (DIR, DIP, BDI) is a metric that describes how long the company can operate without access to noncurrent assets. It is a kind of liquidity index. The advantages of using this metric include:
- Improved insight into liquidity and cash flow: By assessing the length of time a company can operate without access to noncurrent assets, companies can gain important insights into their liquidity and cash flow. This information can be used to make informed decisions about the use of available capital in the future.
- Enhanced financial planning: By knowing the defensive interval, companies can better plan out their financial operations. This allows them to plan for the long term, not just the short term, and ensure their financial security.
- Improved risk management: With the defensive interval, companies can better assess and manage their risks. Knowing the amount of time they can operate without noncurrent assets helps them to plan for contingencies and minimize losses.
- Greater insight into financial health: By looking at the defensive interval ratio, companies can gain insight into their financial health. This can help them to identify any potential problems or risks and take action before they become too serious.
Limitations of Defensive interval ratio
The Defensive interval ratio (DIR, DIP, BDI) is a metric that describes how long the company can operate without access to noncurrent assets. It is a kind of liquidity index. In the literature it can be found also as:
- Despite being a useful metric for evaluating liquidity, the Defensive interval ratio has some inherent limitations. First, it does not account for the variability of cash flow or the impact of changes in financial markets on liquidity. Also, the DIR does not take into account the potential need for capital expenditures or other investments that may be necessary in order to maintain the company's market position.
- Additionally, the DIR does not provide a comprehensive picture of the company's financial health, as it does not take into account other elements such as debt structure, fixed costs, and other liabilities. Furthermore, the DIR does not factor in any changes in the price of the company's assets, which may have an impact on its liquidity.
- Finally, since the DIR does not include any information about the company's working capital, it is unable to accurately predict the company's ability to cover its short-term liabilities. Therefore, the DIR should be used as one of many measures for assessing a company's liquidity, rather than as the sole metric for doing so.
Defensive interval ratio is a metric that describes how long the company can operate without access to noncurrent assets, and there are several related approaches in the literature.
- Cash Flow Adequacy Ratio (CFAR) - is a ratio which measures a company's ability to cover its short-term financial obligations with its operating cash flow.
- Quick Ratio - is an indicator of a company's short-term liquidity. It measures whether a company has enough resources to pay its current liabilities without needing to sell its inventory.
- Current Ratio - is a measure of a company's ability to pay its short-term liabilities with its current assets.
In summary, the Defensive Interval Ratio is a metric that measures how long the company can operate without access to noncurrent assets. There are several related approaches in the literature, such as the Cash Flow Adequacy Ratio, Quick Ratio, and Current Ratio.
Defensive interval ratio — recommended articles |
Burn Rate — Accounting ratios — Activity ratios — Average collection period — Operating cash flow ratio — Return on net assets — Solvency ratios — Days payable — Du Pont analysis |
References
- Durrah, O., Rahman, A. A. A., Jamil, S. A., & Ghafeer, N. A. (2016). Exploring the relationship between liquidity ratios and indicators of financial performance: An analytical study on food industrial companies listed in Amman Bursa. International Journal of Economics and Financial Issues, Nr. 6, p. 435-441.
- Michel Blanchette (2012) Financial ratios and related tools To Your Credit edited by Credit Institute of Canada, Nr. 2011, p. 1-44.
- Zhongwen Tang (2017) Defensive efficacy interim design: Dynamic benefit/risk ratio view using probability of success Journal of Biopharmaceutical Statistics, Nr. 27, p. 683-690.
Author: Paulina Pietroń