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The defensive interval: a better liquidity measure.

The measurement of a firm's short run ability to pay its debts as they come due is a very important aspect of financial analysis. Most credit analysts use the current and quick ratios for this purpose. Are they adequate for the task? Is it reasonable to insist that a firm maintain (or have, on a certain date) a specified ratio of current or quick assets to current liabilities? If these ratios are a valid measure, current and quick assets should provide good indications of short run financial strength; current liabilities should measure the extent of the firm's requirements for current and quick assets; and the resulting ratio of, say, 1.5 should have operational meaning. The current and quick ratios fail to meet these requirements, as I will demonstrate.

There is a measure that meets the test. We call it the defensive interval. However, like Rodney Dangerfield, the defensive interval hasn't received much respect even though it has been around since 1962. The defensive interval measures the time span during which a firm can operate on present liquid assets without resorting to revenues from future income sources. Think of this point for a moment. Why does the treasurer hold defensive assets, such as cash? The reason is that defensive assets act as a buffer against the uncertainty of future cash flows. There will be times when receipts do not come in as quickly as expected or when sales decline temporarily. Conversely, the treasurer might be faced with a sudden increase in expenditures caused, perhaps, by an increase in production in response to an order which must be filled immediately or by the opportunity to make an especially advantageous purchase. Thus, the treasurer's holding of defensive assets enables the firm to meet its requirements for funds without decreasing normal production or incurring additional liabilities.

What are Defensive Assets?

Cash is the most obvious defensive asset. As mentioned, the treasurer holds cash to avoid suffering the costs of being unprotected from the uncertainties of cash flows. The treasurer often holds marketable securities - cash equivalents - in addition to the amount required to meet normal transactions. Marketable securities are also defensive assets. The treasurer usually can easily convert the securities to cash. There is rarely a conversion problem if the securities are short-term U.S. Treasuries, since the face values of these bills, notes and bonds are generally close to their market or cash conversion values. Other investments can present more of a problem.

Accounts receivable are defensive assets. The receivables serve as a substitute for cash, although the amount held at any time is a function of sales and credit policy. If management establishes a realistic allowance for doubtful accounts, the net amount of accounts receivable should be a good approximation of the future debt paying capacity of these assets. It is, of course, true that receivables are not immediately available to meet disbursements. It is also true that all current liabilities seldom require immediate disbursement.

Prepaid expenses and inventory are not defensive assets. Prepaid expenses will not be converted into cash. In fact, by definition, the company has already paid for these assets. With respect to inventory, sales must be made before it is converted into funds available for the payment of debts. Since the amount of defensive assets is important in the event of a delay or decline in sales receipts, it is clearly inappropriate to include inventory in this group.

Why Not Use Current Liabilities?

Implicit in any interpretation of the current and quick ratios is that the current liabilities outstanding at the balance sheet date represent the obligations of the company that are due. But these liabilities are due within the next 12 months - not immediately. Some of them may be due within days; others are not due for months. Also, note that you calculate the current and quick ratios for a particular date - the balance sheet date. The derived ratios fail to capture the flow of funds. A current ratio of 2 simply says that at the balance sheet date, the firm had $2 of current assets for every $1 of current liabilities outstanding. Wouldn't it be better to know how many days the firm's liquid assets could support the business?

I believe the answer to the question is yes. You need to relate the defensive assets to the use for which they are required. This task involves a determination of the amount of present and future operating obligations which will have to be met with the defensive assets, should the inflow of cash be delayed or reduced. Base the estimate of these obligations on the assumption that the firm will continue its operations as in the past. This assumption is reasonable because you are measuring the firm's short term paying ability, rather than its ability to withstand a long term cyclical decline in revenues.

Estimating Operating Obligations

There is a relatively easy way to estimate the operating obligations. Follow these four steps. First, convert accrual sales on the income statement to cash receipts. Add any decrease in this year's accounts receivable balance to sales, and subtract any increase. Second, identify the cash flow from operations amount on the statement of cash flows. Third, subtract the cash flow from operations balance from your cash receipts level. Fourth, divide the difference in step three by 360 days. The result is the estimated daily cash expenses figure. It assumes that the firm incurs the expenses at a constant rate. If you have access to quarterly data, you can calculate the daily expenses using the same procedure. However, instead of dividing the amount for cash expenses by 360, divide by 90 days.

Pulling It Together

Let's pull the defensive interval ratio together. Its definition is:

Defensive interval = Quick assets/Daily cash operating expenses

The number calculated for the defensive interval indicates how many days the defensive assets can continue to support normal operations despite a complete cessation of revenues. You may attack this concept as being unrealistic since a total stoppage of revenue is unlikely. However, think of the revenue cessation as providing a base measure.

Comparison with the Current Ratio

Allow me to make the criticism of the current ratio more explicit now that I've defined the operational meaning of "debt paying ability." Current assets are not the same as defensive assets, since they include prepaid expenses and inventories. Hence, they do not measure the assets that the treasurer has available to pay debts. Even if current assets were the same as defensive assets, the firm's current liability position on the balance sheet date would have to measure correctly its need for these assets. The treasurer can seriously affect this relationship if the amount of current liabilities on the balance sheet is atypical of the average amount of current liabilities. He or she can "fix" the current ratio through the use of "window dressing." Suppose that a firm has current assets (as cash) of $75,000 and accounts payable of. $50,000 with no other current liabilities. Therefore, both the current and quick ratios equal 1.5. If the firm pays $25,000 of its payables it will now have cash of $50,000 and accounts payable of $25,000 with current and quick ratios of 2.1. Yet, it is generally felt that no real change in the debt paying ability of the firm has taken place. On the other hand, if the firm's daily operating expenses don't change, the defensive interval declines as a result of the decline in cash.

Some Real Numbers

To emphasize that the defensive interval may go in an opposite direction to the current and quick ratios, I've gathered information from three well-known companies. Their results are summarized in the table below. You can see that Gillette and Hershey Foods have increasing defensive interval measures for 1995, relative to 1994, whereas their current and quick ratios decline. PepsiCo exhibits opposite results. Its defensive interval shows a decline in 1995 from the 1994 level. However, PepsiCo's current and quick ratios show improvements.

Many firms will show their current, quick, and defensive interval ratios all moving in the same direction. However, it is common to find the relationships shown in the table. I found these diverging results from a survey of only nine firms for which I had annual reports. The issue then becomes one of convincing yourself that the current and quick ratios don't provide the insights about liquidity that you think they do. I feel that it is better to look at a firm's defensive interval over time and see how it is changing. If the defensive interval declines from, say, 20 days to 15 days then the firm has lost 5 days of liquidity to meet daily recurring expenses. It is impossible to put a similar interpretation on a decline in the current or quick ratios from 2 to 1.8. Indeed, as the table shows, the current and quick ratios may be improving as liquidity declines. If this is the case, you may be falsely satisfying yourself that liquidity is better.

The defensive interval departs from the strictly static analysis of the current and quick ratios. It tries to focus your attention directly on the relationship between liquidity and the need for liquidity. The defensive interval uses the existing level of defensive assets as the source of cash, and not future inflow of cash. I believe that if you work with the defensive interval you will find it to be a more rational and useful measure than either the current ratio or quick ratio.

[TABULAR DATA OMITTED]

George Gallinger, Ph.D., is Associate Professor of Finance at Arizona State University, Tempe.
COPYRIGHT 1997 National Association of Credit Management
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Author:Gallinger, George
Publication:Business Credit
Date:Sep 1, 1997
Words:1609
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