Liquidity Ratios: The Defensive Interval Ratio
The __defensive interval ratio__ indicates how many days a firm can meet its expenditures without obtaining additional cash flow. Its calculation is:
$$\displaystyle \frac{\text{cash} + \text{short-term marketable investments} + \text{receivables}}{\text{daily cash expenditures}} $$.
Selected data from XYZ Corp are shown below.
| XYZ Corp | Current period | Prior period |
|------------------------------------|----------------|--------------|
| Cash | 5K | 10K |
| Investments (short term) | 20K | 20K |
| Receivables | 55K | 50K |
| Daily cash expenditures (average) | 1.75K | 1.5K |
From the information in the table, what is XYZ Corp's defensive interval ratio for the current period?
Correct.
Incorrect.
Be sure to add receivables to the numerator.
The defensive interval ratio is a measure of liquidity. The longer a company can meet cash needs without outside borrowing, the more liquid it is. Having more days in this metric signifies that a company is more liquid.
Using data from the table, what does the defensive interval ratio indicate as far as XYZ Corp's liquidity position since the prior period?
Correct.
Incorrect.
Liquidity has not improved.
The calculation is:
$$\displaystyle \frac{5 + 20 + 55}{1.75} \approx 45.7 $$ days.
The calculation for the prior period is:
$$\displaystyle \frac{10 + 20 + 50}{1.5} \approx 53 $$
days. That is more than 45.7 days in the current period, so liquidity has declined. XYZ Corp is considering an extension on its line of credit with the bank. You will advise them this is a wise decision. The current trend is not good, and there may be problems if it continues.
You uncover the data below:
| Rex Retail | Current period | Prior period |
|--------------------------|----------------|--------------|
| DSO | 45 days | 30 days |
| DOH | 15 days | 15 days |
| Defensive interval ratio | 20 days | 30 days |
You suspect that either inventory or receivables are creating the problem by not converting to cash as quickly as before.
From the data in the table, what do you suspect is causing Rex Retailers' defensive interval ratio to decrease?
No.
Inventory levels are stable as the DOH has not increased, but the DSO has gone up, indicating the problem is with receivables.
Correct.
The DOH has remained stable while the DSO has increased. That would indicate that inventory levels are also stable, but receivables have grown quickly or that credit sales have fallen.
To summarize:
[[summary]]
Liquidity problems can sometimes be analyzed by looking at activity ratios and comparing to uncover problems.
Suppose you are analyzing Rex Retailers and have discovered that the defensive interval cycle has taken a big drop from 30 to 20 days in a recent period. You decide to examine the DSO and DOH for clues as to the reasons why this has happened. DSO is a measure for receivables; it indicates the number of days’ worth of sales are tied up in receivables. If the DSO is increasing, it indicates that receivables have grown at a faster rate than sales. The DOH works the same way for inventory. It indicates the number of days’ worth of inventory are on hand. An increasing DOH indicates that inventories are growing faster than sales.
You have identified a problem that is causing the defensive interval to fall. The receivables have grown at a faster pace than sales have. This could be due to accounts' not being paid fast enough or to the enactment of a more lenient credit policy than in the past period. Receivables and inventory need to convert to cash needed to meet obligations. Examining the activity ratios for both can often shed light as to why liquidity ratios may be in decline.
14.6 days
45.7 days
Liquidity has improved
Liquidity has gotten worse
Inventory problems
Receivables are growing too quickly or average credit sales have fallen
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