Defensive Interval ratio or Cash burn ratio measures how long a company can cover its daily expenditures (mainly cash operating expenses) only using current assets available to the entity before it accesses external sources or its own non-current assets for additional cash inflow.
Unlike current ratio and quick ratio that compare current assets (or portion of current assets) with current liabilities, in defensive interval ratio (DIR) entity’s current assets are compared with daily cash expenditures to measure entity’s liquidity position. It serves as a good liquidity indicator as if entity can fulfill its daily cash requirements then it will also be able to carry out its operations on daily basis in an efficient and effective manner which may also translate in stronger financial position and financial performance.
Defensive interval ratio is mainly calculated as follows:
DIR = Defensive assets / Daily cash operational expenditures
Defensive assets are simply the assets that can be liquidated to fulfill cash requirements. Usually these are current assets and thus the same are used for DIR measurement. However, in cases where inventory cannot be liquidated quickly then analysts resort with quick assets of the entity. That is why two variations of it are used:
DIR = Current assets / Daily cash expenditures
DIR = Cash + Marketable investments + Receivables / Daily cash expenditures
For ratio calculation purposes notional operating expenses are excluded. Therefore, expenses like provisions, depreciation and other non-cash expenses are excluded. Calculation is carried out as follows:
Cash operating expenditures = Cost of sales + Admin expenses + Selling expenses + Other operating expenses – non-cash operating expendtures
Daily cash operating expenditures = cash operating expenditures / total days in the period
Usually calculation is done on annual basis and thus total days are either 365 or 360 whichever applies.
Analysis and Interpretation
Just like other liquidity ratios, higher the DIR better the entity’s liquidity. DIR gives the liquidity measure in days which is much easier to gauge and one can the maximum time available before entity will rely on sources of finance other than current assets. Longer the period, more flexible the entity is in terms of liquidity.
Smaller defensive interval may indicate liquidity risk entity is facing or can face in the future. This can potentially alarm investors as well if entity has no future cash inflow arrangements in place like overdraft facility, sales agreement, loans, share issue etc. The cash can be arranged on long term or short term basis.
However, lower defensive interval does not necessarily mean a bad liquidity situation if the rate at which entity is generating cash inflow is equal to cash outflow. If entity is able to generate enough cash from its operations that it can easily pay its daily expenses then it does not need to hold large amounts of cash and cash equivalents. That is why investors and analysts need to consider other aspects of entity as well and must not consider this ratio in isolation.
Defensive interval ratio is meant to corroborate other liquidity ratios instead of replacing them as DIR is using the expense/revenue data that has caused receivables and payables. Therefore DIR complements the decision process by giving another perspective of the entity.
Although the application of DIR seems practical but the results should be taken with caution. Following are the main reasons:
- The daily expenditure calculation is an average taken by dividing expenses in a period over the number of days in the period. And we are assuming that expenses are spread out evenly over the period which might not be the case in reality if a large lump of payment occurs at a particular day. In which actual liquidity might be worse than projected by the ratio.
- We are assuming that there is a steady outflow of cash and a steady cash inflow which cannot be guaranteed in reality. Receipts might be delayed for number of factors and similarly payments might have to take place earlier than expected to get the benefit of cash discount. In this case DIR becomes less reliable.
- One major concern is that figures of current assets are period end balances whereas expense is average of total accumulated over the period. During the year assets like receivables, cash and cash equivalents can be less or more than what period balances indicate. Similarly the average of operating expenses doesn’t necessarily have to be the real representative of daily cash expense. For example if entity has 400,000 annual cash expense and out of it 200,000 alone is fine paid by the entity, this anomaly will change the average expense drastically.
Consider the following extracts from the balance sheet of a certain entity:
|Cash at bank||60,000|
|Total current assets||500,000|
|Annual operating expense||1,440,000|
Entity considers 360 days long year. All operating expenses mentioned are cash based. Inventory is not considered a liquid asset. Industry’s average DIR is 85 days.
Daily operating expense = 1,440,000 / 360 = 4,000
Quick assets = 150,000 + 190,000 + 60,000 = 400,000
DIR = 400,000 / 4,000 = 100 days
As entity’s DIR is more than industry’s average, it may indicate sound liquidity position. Now entity has the option to take leverage of long interval and invest cash.
Following is the relevant data of three different entities:
|Cost of sales||800,000||500,000||100,000|
|Short term investments||50,000||120,000||35,000|
|Cash and cash equivalents||40,000||80,000||(10,000)|
|Expected monthly cash inflow||60,000||14,000||50,000|
|II||Short term investments||50,000||120,000||35,000|
|III||Cash and cash equivalents||40,000||80,000||(10,000)|
|Y = I + II + III||Total quick assets||160,000||480,000||110,000|
|M||Total operating expense (annual)||550,000||350,000||120,000|
|X= M/30||Daily operating expense (rounded)||1528||972||333|
|Y / X||DIR||105||494||330|
|MM||Monthly cash inflow expected||60,000||14,000||50,000|
|D = MM/30||Daily cash inflow (rounded)||2000||467||1667|
|D – X||Daily cash surplus/(deficit)||472||(506)||1333|
From the calculations above you can see the all three entities had quite strong DIR values. The strongest of the three was entity B. But looking at the operating statement B is making losses and also it is facing cash deficit on daily basis.
Lastly, entity C had quite a small revenue and even overdraft but still managed to have strong DIR and also the huge cash surplus on daily basis.