The defensive interval ratio is considered to be one of the most valuable liquidity ratios. Expressly, it focuses on calculating how many days it takes for a company to pay for its operating expenses by utilizing its most liquid assets, without reaching external financing resources.
Therefore, it is a highly valuable tool that assesses a company’s liquidity risk. A company’s capability of surviving on liquid assets displays a strong, powerful business that doesn’t depend on external support to function. This is why a high defensive internal ratio is regarded as being favorable. However, this doesn’t mean that analysts should overlook other elements, such as the specifications of the industry, which are of great importance.
The reason why a company has to monitor this ratio is to comprehend the liquidity situation, and how it changes during different periods. Evidently, some businesses have a cyclical operation. For example, let’s take the tourism industry. Even if some customers might choose to book their holidays early, they take the trips during the holiday seasons – for the most part. With that in mind, during the booking season, the company is likely to get a lot of cash. Nevertheless, it still depends on the customers to actually make the trip. So, during this timeframe, the revenues will be quite low, requiring the companies to deal with daily operations through internal sources.
During the holiday season, though, the trend is prone to change. This is the time when the company starts to get revenue for the bookings. These being said, it is essential for the firm to analyze the liquidity situation in specific periods and compare it with its performance from the previous years.
The Formula
Financial analysts must carefully evaluate the financial notes and statements to analyze the details of all the items mentioned in the formula above. It is critical to point out the daily expenses and underlying defensive assets accordingly to get a fair outlook.
Moving on, the defensive assets represent the sums of cash, trade receivables, and marketable securities. Meanwhile, the daily operational expenses include the per day operating expense, without taking into account non-cash items such as depreciation.
Furthermore, we would like to outline that many financial analysts consider that the defensive internal ratio is much more helpful in comparison with a current ratio or a liquidity ratio. That is, for the most part, because it compares assets to expenses as opposed to comparing assets to liabilities.
Final Thoughts
To conclude, you should know that a higher DIR is considered to be more favorable. That’s because it facilitates more liquidity for the company. Nevertheless, in some cases, too many liquid assets might have a negative impact on the firm’s operations. It might also mean that the firm doesn’t employ its capital effectively, in order to bring higher returns.