I am struggling that sometimes CFA curriculum uses ending balance for calculating ratios and sometimes it uses average balance for Balance Sheet-related accounts. For instance, CFA curriculum’s Example 5 in chapter Inventories uses Average Balance but Example 4 uses ending balance for calculating leverage ratios (A/E). It’s quite confusing.
I’d appreciate if anyone can share thoughts on what is acceptable, and how do we know when to choose what. Thanks in advance.
With ratios that include income statement and balance sheet accounts (e.g., ROA, ROE), it’s common to use average values for the balance sheet numbers. Similarly for ratios that include cash flow statement and balance sheet accounts.
For pure balance sheet ratios (e.g., debt-to-assets, financial leverage), it’s common to use ending balance sheet values.
The common exception to that latter rule is the financial leverage value used in the DuPont breakdown of ROE: use average equity and average total assets (because we’re breaking down ROE which uses an income statement account (net income) and a balance sheet account (equity), so the balance sheet number is an average).
Here’s the WHY of using averages for BS numbers in “mixed” ratios (i.e. an IS number and a BS number in the same ratio).
Remember that the IS measures performance over a time period, while the BS measures at a point in time. So, to some extent, they’re inconsistent - if you you measured (e.g.) ROA using end of period assets and the firm had downsized over the year, you’d get a number that’s artificially high. If we didn’t use average BS numbers in these cases (i.e. when there’s a difference in firm size over the year), we’d get a number that’s “off”.
However, if both numbers in the ratio are either IS or BS, they’re capturing the same time period (IS) or point in time (BS), so there’s no need to adjust.