Defensive interval ratio definition
/What is the Defensive Interval Ratio?
The defensive interval ratio compares a set of liquid assets to expenditure levels to determine how long a business can keep paying its bills. The presumed source of funds for this calculation is a firm’s most liquid current assets; all other assets are excluded.
There is no correct answer to the number of days over which existing assets will provide sufficient funds to support company operations. Instead, review the ratio over time to see if the defensive interval is declining; this is an indicator that the company’s buffer of liquid assets is gradually being reduced in proportion to its immediate payment obligations. If this trend continues, then the business will either need a cash infusion or it will eventually enter bankruptcy proceedings.
How to Calculate the Defensive Interval Ratio
To calculate the defensive interval ratio, aggregate the amounts of cash, marketable securities, and trade accounts receivable on hand, and then divide by the average amount of daily expenditures. Note that the denominator is not the average amount of expenses, since this can exclude any ongoing expenditures made for assets. Also, only put trade accounts receivable in the numerator, since other receivables (such as from officers of the company) may not be collectible in the short term. The formula is:
(Cash + Marketable Securities + Trade accounts receivable) ÷ Average daily expenditures
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Example of the Defensive Interval Ratio
Hammer Industries is suffering through a cyclical decline in the heavy equipment industry, but the cycle appears to be turning up. The company expects a cash-in-advance payment from a major customer in 60 days. In the meantime, the CEO wants to understand 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 calculation of the defensive interval ratio is:
($1,200,000 Cash + $3,700,000 Marketable securities + $4,100,000 Receivables) ÷ $138,500 Average daily expenditures
= 65 days
The ratio reveals that 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 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.
There are several issues with this calculation that should be considered when evaluating its results, which are noted below.
Expenditure Inconsistency
The central flaw is that the average amount of expenses that a business incurs on a daily basis is not consistent. On the contrary, it is extremely lumpy. For example, there may be no significant expenditure required for several days, followed by a large payroll payment, and then a large payment to a specific supplier. Because of the uneven timing of expenditures, the ratio does not yield an overly accurate view of exactly how long a company’s assets will support operations.
Receivable Replenishment
The cash and accounts receivable figures used in the numerator are constantly being replenished by new sales, so there should be more cash available from this source than is indicated by the ratio.
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.