Defensive Interval Ratio (DIR)
In 1944, the US dollar became the world’s reserve currency, and steadily it became the default currency for international trade. This is why globalization and international trade helped the US economy flourish for over eight decades.
However, the presently unfolding tariff tensions may end up disrupting business models across the US, especially those directly dependent on foreign inputs or foreign demand. Such economic shocks can paralyze a company’s operations.
Hence, defensive cash buffers have become more important than ever before.
In this article, we will introduce you to defensive interval ratio (DIR), a liquidity metric that helps gauge whether a company has sufficient cash reserves. Then, we will explore the DIRs of various sectors and their liquidity needs.
What is the defensive interval ratio (DIR)?
The defensive interval ratio (DIR) is a liquidity ratio that measures the number of days a company can continue operating by relying only on current assets. Current assets include cash and other assets that can be converted into cash within a year. DIR is an important metric that helps assess a company’s ability to survive a crisis where cash flow inflows are dwindling and raising funds through debt or equity is not viable.
Defensive interval ratio (DIR) formula
Defensive interval ratio (DIR) = Current assets/Daily operational expenses
DIR, which is measured in days, is also known as the defensive interval period (DIP) or the basic defense interval (BDI).
How to interpret the defensive interval ratio (DIR)?
In general, companies benefit from having high DIRs. The only downside to an extremely high DIR could be the possibility that the company is passing up expansion opportunities. However, a high DIR allows companies to accumulate cash reserves, which can later be deployed strategically for expanding operations.
The importance of DIR increases as crises loom, specifically when cash inflows start to fall due to decreasing demand.
DIR can also be important in industries that experience seasonal demand. If a company in such industries suffers from a low DIR, it may have to eventually rely on debt, which can reduce investor returns.
Defensive interval ratios (DIRs) across various industries
We collected average DIRs for 183 industries across 15 sectors. Here, we will analyze the liquidity of these 15 sectors. By arranging the data in the form of a histogram, we can observe that most industries have DIRs of less than 23.08. This means that they can rely on their current assets to keep operating for less than a month. The average DIR of all industries is 10.71.
However, the industries of equipment rental and leasing services (not elsewhere classified) and help supply services have average DIRs greater than 200. So, these industries could potentially continue operating for at least half a year by relying solely on current assets.
On the other hand, in industries such as general residential building contractors and radio broadcasting stations, the average DIR is 0. Companies in these industries must continuously generate cash flows, liquidate assets, or risk ceasing operations.
Sector-wise trends
Among 15 sectors, the business and professional services sector stands out with the highest average DIR of 57.83. This sector is closely followed by the construction and real estate sector, which has an average DIR of 21.46.
Interestingly, when we arrange the industries by their average DIRs in descending order, the standard deviation and maximum DIR values also tend to follow a similar descending pattern. This suggests that the top sector’s average DIRs have been skewed by extremely high maximums.
| Sector | Number of industries | Average DIR | Median DIR | Standard deviation | Minimum DIR | Maximum DIR |
|---|---|---|---|---|---|---|
| Business and professional services | 11 | 57.83 | 7.91 | 96.33 | 0.46 | 255.39 |
| Construction and real estate | 9 | 21.46 | 2.66 | 45.61 | 0.86 | 141.55 |
| Industrial manufacturing | 21 | 11.46 | 4 | 27.78 | 0.01 | 130.41 |
| Utilities and infrastructure | 27 | 10.9 | 2.26 | 30.29 | 0.19 | 152.12 |
| Energy and natural resources | 4 | 9.38 | 3.1 | 14.42 | 0.42 | 30.9 |
| Transportation and logistics | 5 | 7.7 | 6.23 | 7.89 | 0.09 | 20.71 |
| Other industries | 47 | 7.69 | 2.42 | 16.6 | 0 | 98.94 |
| Technology and electronics | 5 | 4.61 | 4.75 | 2.09 | 1.49 | 7.25 |
| Chemicals and materials | 12 | 4.56 | 2.19 | 4.82 | 0.37 | 15.53 |
| Financial services | 4 | 4.06 | 5.23 | 2.68 | 0.08 | 5.71 |
| Healthcare and pharmaceuticals | 5 | 3.06 | 2.05 | 3.46 | 0.12 | 9.04 |
| Defense and aerospace | 3 | 2.59 | 0.45 | 4.05 | 0.06 | 7.27 |
| Retail and consumer goods | 10 | 1.75 | 1.34 | 1.38 | 0.5 | 4.96 |
| Other services | 16 | 1.25 | 0.63 | 1.63 | 0 | 5.81 |
| Entertainment and media services | 4 | 0.96 | 0.46 | 1.29 | 0.05 | 2.86 |
High-performing sectors
Sectors: Business and professional services, construction and real estate, industrial manufacturing
The business and professional services sector is extremely asset-light. As a result, businesses in this sector can have a high concentration of current assets on their balance sheets. These businesses have irregular and unpredictable revenue patterns. Hence, such firms must maintain substantial cash buffers.
In contrast to the business and professional services sector, the construction and real estate sector is asset-heavy. Since there’s often a substantial gap in the timing of cash outflows and cash inflows, companies in these sectors must maintain substantial cash reserves for procuring materials, payroll expenses, and other project-related expenses. This would also suggest that the average DIR in the construction and real estate sector would decline while projects are in progress and increase as payments are collected.
The industrial manufacturing sector is similar to the construction and real estate sector in its asset-heavy nature and high operational costs. However, this sector has comparatively smaller gaps between the timing of cash outflows and cash inflows.
Sectors with moderate DIRs
Sectors: Utilities and infrastructure, energy and natural resources, transportation and logistics, other industries
The utilities and infrastructure sector benefits from long-term contracts with private and public entities. The predictability of cash flows makes it easier for companies in this sector to accumulate and maintain cash reserves. Companies in this sector have significant capital expenditures (capex), but fortunately, there typically isn’t a large gap between the timing of capex outflows and revenue.
Since the energy and natural resources sector has exposure to commodity price volatility, companies in this sector try to maintain high liquidity. Furthermore, with natural resource exploration and oil production, there is always a possibility of dry spells, making liquidity management crucial.
The transport and logistics sector has predictable operating costs, which make it easier for companies to maintain sufficient cash reserves. Nevertheless, fuel price volatility can place strain on the operations of such companies.
Sectors with low DIRs
Sectors: Technology and electronics, chemicals and materials, financial services, healthcare and pharmaceuticals, defense and aerospace, retail and consumer goods, other services, entertainment and media services
Low DIRs in the sectors of technology and electronics, chemical and materials, and healthcare and pharmaceuticals do not necessarily indicate negative performance.
The technology and electronics sector has various high-growth companies that would prefer reinvesting profits into product development and other growth initiatives. They can afford to do so because of the asset-light nature, fast revenue cycles, and easy access to capital due to high investor confidence.
Since the chemical and materials sector is integrated with various other industries, it enjoys demand stability. The sector has entered a period of stability after sustaining high growth for years.[1] Hence, companies in this sector can afford to prioritize investments in plants and raw materials over building cash buffers.
Institutions such as hospitals have complex reimbursement systems, which lead to unpredictable cash collection. Companies involved in the development of drugs and medical devices must make significant research and development (R&D) investments. However, these cashflow-related drawbacks are offset by government subsidies to a certain extent.
DIR might not be an appropriate metric to measure the liquidity of the financial services sector. Financial services companies such as investment firms and insurance providers may need to deploy funds instead of holding cash for defensive purposes. Additionally, certain industries in this sector can have predictable and fast revenue cycles.
Similarly, the need for cash buffers is reduced by moderately predictable demand in the retail and consumer goods sector.
In contrast, the entertainment and media services sector suffers from unpredictable cash flows. At the same time, any generated cash flows might need to be reinvested for content creation. As a result, the sector has a low DIR.
Note: The extreme maximums and large standard deviations suggest that industry-specific factors can have a major influence on DIRs.
Eqvista- Deciphering value with tenacity!
Our research suggests that DIRs are high out of necessity in industries where cash flows are unpredictable due to factors such as input price volatility and cash collection delays. On the other hand, businesses that benefit from stable demand and input prices can have low DIRs as they are likely to reinvest profits to pursue growth opportunities.
Hence, it is important not to take DIR figures at face value and understand industry dynamics before forming an opinion about a company’s liquidity management.
Eqvista’s seasoned valuation experts understand the importance of such nuances and always strive to decipher the story hidden behind data.
Contact us to get an accurate and audit-defensible valuation report!
