FINANCIAL TOOLS OF ANALYSIS: THE BASIC DEFENSIVE INTERVAL ( Part 1 of 4 ) In 1924 Dr. Theodrore Beckman of Ohio State University authored one of the first textbooks that pertained to credit management. Beckman believed that credit managers need extensive training in order to complete credit related tasks. There is little chance that Beckman could have foreseen the rapid transformation of the credit function into the high level skill occupation that it has now become. The financial tools that can be useful to top level credit managers are quite often complex. Company specific distinctions require the use of skills that vary from company to company. Yet there is one common thread found in the best credit managers: visionary credit managers know the numbers cold. Visionary credit managers know when and how to employ financial tools of analysis. In a four part series of articles certain contemporary financial tools of analysis will be examined. This article will focus upon the BASIC DEFENSIVE INTERVAL (BDI). Readers should feel free to send an e-mail to the author if there is a particular financial tool that you believe is pertinent to credit management; perhaps another series of articles that examines financial tools could be presented next year. RATIONALE FOR USING THE BDI Often times the failure of a business is preceded by a liquidity crisis. Traditional measures of liquidity that are often useful to credit managers include: cash flow, working capital, the current ratio and the quick ratio. The basic defensive interval (BDI) is simply another tool that could be useful as a measure of liquidity. In particular, the financial position of e-commerce companies can often reflect severe shortages of cash. The concern for just how quickly an e-commerce company can “burn” through its cash is quite pertinent to managing credit. Moreover, the problem of running out of cash is not limited to internet companies. THE BDI CALCULATION The BDI calculation is rather straightforward. The BDI is calculated in two steps: First calculate daily operating expenses which entails adding cost of goods sold (CGS) to selling, general and administrative(SGA) expenses and then dividing the total by 365. The Second step is to calculate the BDI by summing cash, marketable securities and accounts receivable and then dividing by the daily operating expenses obtained in step one. The following example is used to illustrate the BDI calculation. The cash, marketable securities, and accounts receivable are found in a Balance Sheet. The cost of goods sold and the selling, general and administrative expenses are found in an Income Statement. Step 1. Cost of Goods Sold $4,200,000 Selling, General and Administrative Expenses 3,800,000 Daily Operating Expenses $8,000,000 divide by 365= $21,918 Step 2 Cash $ 50,000 Marketable Securities 120,000 Accounts Receivable 430,000 $600,000 divided by $21,918 = 27.4 Days = BDI USING THE RESULTS The BDI calculation may be straightforward; however the interpretation can be a bit tricky. The results used in the example suggest that a firm should be able to meet cash obligations for 27.4 days. A particular customer may have the ability to meet obligations but that does not mean that the customer will have the willingness to meet obligations. Questions need to be asked concerning the BDI. The amount of cash available can vary widely by industry. Is the trend for the BDI period changing? Does a business have alternative sources of cash available such as a bank line of credit? How long can an e-commerce company continue to burn through cash without generating a profit? What other key factors shape the credit decision? The basic purpose of the BDI is to determine how long a firm can continue to meet its cash obligations from liquid assets. The judgement of a particular credit manager will suggest when and how the BDI can be of use. The BDI is simply one more tool that could prove to be of use to a visionary credit manager. NEXT MONTH’S TOOL: The Economic Value Added ( EVA ) About The Author: Dr. Chuck Gahala, CCE can be reached via e-mail : email@example.com Dr. Gahala is a Finance Professor at Benedictine University which is located in Lisle, Il where he is the Chair of the Undergraduate Business Department. Dr. Gahala specializes in the area of corporate finance and business credit management. He is the author of Credit Management: Principles and Practices published by NACM. He holds NACM’s CBF and CCE credentials.