Current Assets to Total Debt Ratio (with Example)

The Current Assets to Total Debt Ratio is an important financial metric used by analysts, investors, and financial managers to assess a company's liquidity and its ability to meet its total debt obligations with the assets it holds that are expected to be liquidated within one year. It is a key ratio for evaluating a firm's short-term financial health, especially in the context of its ability to cover its total liabilities with its most liquid resources. The ratio provides valuable insights into how well a company can use its current assets to service its debts, and it serves as an important tool in credit risk analysis and overall financial stability evaluation.

Understanding Current Assets

Before delving into the Current Assets to Total Debt Ratio, it is essential to understand what constitutes current assets. Current assets are the assets of a company that are expected to be converted into cash or consumed within one year or within the normal operating cycle of the business, whichever is longer. These include:

Cash and Cash Equivalents: This includes cash on hand, bank accounts, and highly liquid assets that are easily convertible to cash with minimal risk of loss.

Accounts Receivable: Amounts due from customers or clients for goods or services provided but not yet paid for. These are expected to be collected within a short period, usually within 30 to 90 days.

Inventory: Goods and raw materials that are held by the company for sale or for use in the production process. Inventory is expected to be sold or used within the company's operating cycle.

Marketable Securities: Investments in stocks, bonds, or other securities that are expected to be sold or converted into cash within a short period.

Prepaid Expenses: Payments made in advance for services or goods that will be consumed within a year, such as insurance premiums or rent.

The total value of these assets gives a snapshot of how much liquidity a company has on hand to meet short-term obligations. This liquidity is crucial for day-to-day operations and for avoiding financial distress.

Understanding Total Debt

The term total debt refers to a company’s overall debt obligations, which include both short-term and long-term liabilities. Short-term debts are those that are due within a year, such as accounts payable, short-term loans, and other current liabilities. Long-term debt, on the other hand, includes loans, bonds, and other borrowings that are due beyond one year.

Total debt, therefore, is the sum of a company's short-term and long-term debt obligations, and it reflects the total financial leverage used by the company. High levels of debt can indicate increased financial risk because the company must use its income or assets to pay off the debt, potentially limiting its ability to invest in new opportunities or grow the business.

Interpretation of the Ratio

The Current Assets to Total Debt Ratio offers insights into a company’s financial position in several ways:

High Ratio (Greater than 1): A ratio greater than 1 implies that a company has more current assets than total debt, suggesting that it can cover its total debt obligations with its liquid assets. This is a positive indicator of liquidity and financial health. Companies with higher ratios are generally considered less risky by lenders and investors, as they are more likely to meet their debt obligations even in difficult financial times.

Ratio Close to 1: A ratio close to 1 suggests that the company has just enough current assets to cover its total debt. While this is not necessarily a bad position, it can indicate limited liquidity. The company may face difficulties in managing unexpected expenses or downturns in its business, as any unforeseen circumstances could stretch its ability to meet both short-term and long-term debt obligations.

Low Ratio (Less than 1): A ratio lower than 1 indicates that the company does not have enough current assets to cover its total debt, which can be a cause for concern. This suggests that the company may need to rely on its long-term assets or external sources of financing to meet its debt obligations. A low ratio often signals financial distress or potential insolvency risks, particularly if the company does not have a clear path to generate enough cash flow to meet its debts.

Factors Affecting the Ratio

Several factors can impact the Current Assets to Total Debt Ratio, and understanding these factors is essential for interpreting the ratio effectively:

Industry Norms: Different industries have different operating cycles and capital structures, meaning the acceptable level of the ratio may vary by sector. For example, industries with high capital expenditures, such as manufacturing or infrastructure, may have higher levels of long-term debt and lower current asset ratios. Conversely, businesses in retail or services may have lower levels of debt and higher liquidity ratios. Therefore, comparing a company’s ratio with industry averages is critical for context.

Debt Structure: A company with a high level of long-term debt relative to short-term debt may still be financially stable, even if the Current Assets to Total Debt Ratio is low. This is because long-term debt is not due in the near future, and the company may have enough time to generate cash flow to service its obligations. On the other hand, a high proportion of short-term debt may require immediate liquidity, making a strong ratio essential.

Operational Efficiency: A company’s ability to manage its operations efficiently can affect the liquidity position. A company with efficient inventory management, effective receivables collection, and tight cash flow controls is likely to have a stronger ratio. Poor operational management can deplete current assets, leading to a lower ratio.

Economic Conditions: The broader economic environment plays a significant role in determining a company’s ability to manage its debts. During periods of economic growth, businesses may see increased revenues and a stronger liquidity position, improving their Current Assets to Total Debt Ratio. Conversely, during economic downturns, a company may experience slower cash inflows, which could lower the ratio.

Company Strategy: Companies with aggressive growth strategies, such as expanding operations or investing heavily in new projects, may have higher debt levels and lower liquidity ratios. However, if these investments lead to long-term profitability and higher future cash flows, they could offset short-term liquidity concerns.

Limitations of the Ratio

While the Current Assets to Total Debt Ratio is a useful tool for assessing a company’s liquidity, it is not without limitations:

Timing of Asset Conversion: Not all current assets are equally liquid. For example, accounts receivable may take time to collect, and inventory may not always be easily converted into cash. Therefore, relying solely on the ratio may not provide an accurate picture of a company's true liquidity position.

Debt Characteristics: The ratio does not distinguish between short-term and long-term debt. Since short-term debt requires immediate repayment, a company with significant short-term debt may face liquidity issues, even if the ratio is high. Conversely, a company with more long-term debt may have more time to manage its liabilities but still appear less liquid based on the ratio.

Exclusion of Non-Current Assets: The ratio focuses only on current assets and total debt, ignoring the company’s long-term assets, which could provide additional financial resources in times of stress. For example, a company with valuable real estate or intellectual property may be able to use those assets to secure financing or sell them to cover liabilities.

Formula:
Current Assets to Total Debt = Total Current Assets / (Short-Term Debt + Long-Term Debt)

Example:
CIM Ltd. has the following data:
Stocks $70,000
Trade debtors $30,000
Sundry debtors $20,000
Bills receivables $40,000
Cash $26,000
Prepaid electricity $4,000
Accrued rent $18,000
Creditors $50,000
Salary payable $32,000
Bank overdraft $52,000
Bank loan $48,000
Debentures $100,000

Then,
Total Current Assets = Stocks + Trade debtors + Sundry debtors + Bills receivables + Cash + Prepaid electricity = 70,000 + 30,000 + 20,000 + 40,000 + 26,000 + 4,000 = $190,000
Total Debt = Accrued rent + Creditors + Salary payable + Bank overdraft + Bank loan + Debentures = 18,000 + 50,000 + 32,000 + 52,000 + 48,000 + 100,000 = $300,000
Current Assets to Total Debt ratio = 190,000 / 300,000 = 0.63

Conclusion

The Current Assets to Total Debt Ratio is a vital tool for assessing a company's ability to meet its debt obligations using its most liquid assets. By providing insight into a company’s short-term liquidity position, the ratio helps investors, creditors, and financial managers evaluate financial stability and risk. A high ratio suggests strong liquidity and financial health, while a low ratio may signal potential financial distress. However, this ratio should be considered alongside other financial metrics, such as cash flow, debt maturity profiles, and industry-specific factors, for a more comprehensive understanding of a company’s financial position. By carefully analyzing the Current Assets to Total Debt Ratio, stakeholders can make more informed decisions regarding a company’s creditworthiness and overall financial well-being.