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Inventory Coverage Ratio

Inventory Coverage Ratio - a financial sustainability ratio showing if the company has enough sources of finance for the stock forming. The indicator can be computed by dividing the normative sources of finance (working capital and short-term liabilities) by the company’s inventories. The ratio value measures the share of inventories, which are covered by the normative sources of finance (stockholders’ equity, short-term and long-term liabilities, etc.).

The value of this indicator must be higher than 1. It only happens to be lower than 1 in case of the negative stockholders’ equity, which indicates the possible bankruptcy of the company in the near future. In normal conditions the value of the inventory coverage ratio will necessarily be higher than 1. In any case, the dynamics of the ratio values should be analyzed. Positive is an increasing trend of this ratio, which indicates the growth of the company’s financial sustainability.

Resolving the problems with the inventory coverage ratio exceeding the normative range:

In case the company doesn’t possess enough funds for the stock forming, it should develop the plan of recovering its financial sustainability. The solution for this might be the additional capital raising.

Formula(s):

Inventory Coverage Ratio = (Working Capital + Short-Term Liabilities) ÷ Inventories

Example:

Company A

Balance Sheet

$

as of

31/12/YEAR1

$

as of

31/12/YEAR2

Assets
I. NONCURRENT ASSETS
TOTAL 340 341
II. CURRENT ASSETS
Inventories 98 99
TOTAL 455 413
Balance 795 754
Liabilities
III. STOCKHOLDERS'EQUITY
TOTAL 432 455
IV. LONG-TERM LIABILITIES
TOTAL 85 85
V. SHORT-TERM LIABILITIES
TOTAL 278 214
Balance 795 754

Inventory Coverage Ratio (Year 1) = ((432 + 85 - 340) + 278) ÷ 98 = 4,64

Inventory Coverage Ratio (Year 2) = ((455 + 85 - 341) + 214) ÷ 99 = 4,17

The company had enough sources of finance for maintaining its operations during the analyzed period. Despite a slight decrease of the inventory coverage ratio from 4,64 in year 1 to 4,17 in year 2, the financial stability of the firm still was on a good level since the ratio value remained higher than 1. For each dollar of inventories there were 4,17 dollars of financial resources available at the end of year 2.

Conclusion:

Inventory coverage ratio is one of the indicators of the company's financial sustainability, which measures the amount of the normative financial resources, such as the working capital and short-term liabilities, available per each dollar of inventories. This ratio measures the firm's ability of creating the stock reserves.