hi guys - re the financial leverage ratio: on page 239 of the CFA book (and in an EOC question in the ‘balance sheet’ chapter) they define it as total assets / total equity. then in the financial analysis techniques chapter, (see page 333) it’s average total assets / average total equity. any thoughts on what one to use? in the balance sheet EOC question, they definitely haven’t used averages. thanks much.
I have been using Total Assets / Total Equity. I did see that while going through my readings. (I believe it was when calculating Book Value…) I was always under the impression that you only use Average amounts from Balance sheet items when you are comparing and Income Statement Item with a Balance Sheet Item, i.e Inventory Turnover = COGS / Average Inventory.
I just assume that when they give balance sheet data for 2 years, they want you to compute using an average. Same as how when they give you enough data to calculate the required return on equity more than one way, they want you to take the average of the several answers.
Think of the formula as the method but the technique as a best practice. I read somewhere in the book that the reason why average is a preferred method is so not to understate or overstate the ratios and to arrive at a better analysis. Consider that you take Total Assets /Total Equity - Now just prior to the reporting period the company the Assets are reduced dramatically. Automatically the leverage ratio falls. Now some of those assets (sold/reduced) were used in generating income/profit etc. Therefore it is only appropriate to use them (and the average method) in the calculation for consistency over time and reflection of what actually transpired.