When using balance sheet numbers in ratios, seemed that FSA always suggested using averages, which makes sense. However, in reading Corporate Finance, I am finding that even if the ratio/formula uses the word “average”, it does not in practice. WTF! Examples from CFAI Text in Corp Finance volume: Pg 91, Inventory Turnover = Cost of Goods Sold/Average Inventory Yet the solution for practice problem #3 on page 130 (solution is on A-9) uses the ending inventory balance rather than the avg to calculate inventory turnover. I have seen this in other problems as well. Second, and even more blatant example is on page 137 of the same book (Corp Finance). Book says Revenues/Avg Total Assets, yet about an inch below it plugs the ending balance ($6767) for the Avg Total Assets??? There is nothing in the errata and as I said, this is repeated multiple times. Any thoughts?
I think that very often in practice instead of using averages they use just ending balances. It is much more accurate to use average data when calcualting ratios that make references to balance sheet data, indeed. If the balance sheet data do not fluctuate significantly than there is no significant error just using end-year balance. The difference is more visible and significant when fluctuations are significant.
The mathematically correct answer is to use averages, but in practice an analyst will sometimes use the ending balance if it’s more representative of the situation. Inventory is the most often used example that I’ve seen because you’re often more interested in what it looks like now because you’re more interested in predicting the future than the past.
i think when use use values from income statement and balance sheet , you will be using averages. for ex… Inventory Turnover=COGS/avg Inventory
in FSA you use Averages in Corporate Finance you don’t. At least that’s what was told in the Stalla lecture. No rhyme or reason, that’s just the way they are testing it.
That’s what I was getting at, in Corporate Finance you’re usually making projections so things like current inventory levels are usually more relevant for forecasting that what they averaged over the previous period. Particularly when there’s growth the prior periods average is probably going to cause you to low ball your projections.
That makes sense in terms of Corp Finance vs FSA and I suppose that is the rule that I will follow. But still, it is a bit disconcerting that in Corp Finance they use the term “Averages” in the formula, but do not use the average when solving, so the contradiction within Corp Finance is still there.
I think that when they do not use averages it is only simplification. Remember that any posission in IS accrues throughout the whole financial year and all positions on BS are only pictures of a moment and it may not be very representative for the whole period. For example if a company purchases a bulk of inventory at the year end your average will be overstated. Taking into account that a company maintains lower level of inventory throughout the year and the purchase at the year end is only due to for example tax advantages then it is not very representative to calculate inventory turnover based on openning and ending inventory… What do you think?