Some ratios compare two balance sheet figures, some compare two income statement figures, and some mix the two. The mixed ratios raise a timing question: which balance to set against a full period of income. This guide explains why many of them use an average balance, how much the choice can change a result and how the calculators on this site handle it.
Period figures and point-in-time figures
The income statement measures flows over a period. Revenue, cost of goods sold and net income build up from the first day of the year to the last. The balance sheet measures what the business held at a single moment, such as total assets, inventory or receivables at the close of business on one date.
A ratio such as return on assets asks how much profit the business earned on the assets it used during the year. Those were the assets it held across the year, not only those it held on the last day. If the balance changed during the year, the closing figure describes the end of the period rather than the period as a whole.
Averaging the opening and closing balances is a simple way to approximate the balance across the period. The opening balance is the previous period’s closing balance, which most annual reports show as a comparative column on the balance sheet. The average assumes the balance moved evenly between the two dates.
When no average is needed
Averaging only matters when a ratio mixes the two kinds of figure. The current ratio, quick ratio, cash ratio, debt-to-equity and debt-to-assets compare two balances, so both should come from the same balance sheet date. Profit margins and interest coverage compare two figures for the same period, so both come from the same income statement.
Ratios on this site that use averages
These calculators use the average of the opening and closing balance when you enter both:
- Return on assets: average total assets.
- Return on equity: average shareholders’ equity.
- Return on invested capital: average invested capital.
- Asset turnover: average total assets.
- Inventory turnover: average inventory.
- Days sales outstanding: average accounts receivable.
- Days payable outstanding: average accounts payable.
- Cash conversion cycle, when calculated from financial statement figures: average inventory, receivables and payables for its three parts.
- DuPont analysis: average total assets for asset turnover, and average total assets and average shareholders’ equity for the equity multiplier.
Earnings per share applies the same idea in another form. It divides a period’s profit by the weighted average number of shares outstanding, so shares issued halfway through the year count for half the year.
How the choice changes the result
Take a business that starts the year with total assets of 400,000 and ends it with 600,000 after buying new equipment. Its revenue for the year is 900,000 and its net income is 50,000. The average of the opening and closing balances is (400,000 + 600,000) ÷ 2 = 500,000.
| Ending balance | Average balance | |
|---|---|---|
| Total assets used | 600,000 | 500,000 |
| Return on assets (50,000 ÷ total assets) | 8.3% | 10.0% |
| Asset turnover (900,000 ÷ total assets) | 1.50 | 1.80 |
Profit and sales are the same in both columns, yet return on assets differs by almost 1.7 percentage points. Because total assets grew, the ending balance is larger than the average and makes both ratios lower. When a balance falls during the year, the effect reverses. Day-count measures such as days sales outstanding move the other way, because the balance sits in the numerator: a larger balance means more days.
Net income of $50,000 divided by average total assets of $500,000 gives 10.0%. Divided by closing total assets of $600,000, the same profit gives 8.3%, because assets grew during the year.
How the calculators handle a missing opening balance
Each of these calculators asks for the closing balance as a required figure. The opening balance sits under “Add opening balances to use averages”.
- With an opening balance, the calculator averages it with the closing balance and shows the averaging as a step in the working.
- Without one, it uses the closing balance on its own and adds a note to the result saying so.
- A blank is not zero. Enter 0 only if the balance really was zero at the start of the period. The calculator then averages zero with the closing balance, which halves it.
- Each balance is handled separately. DuPont analysis and the cash conversion cycle from statement figures use more than one balance. If you enter some opening balances but not others, part of the result uses averages and part uses ending balances, and the notes list each balance that fell back. Enter all the opening balances or none.
When ending balances are reasonable
Averages are not always needed, and sometimes they are not possible. The ending balance is a reasonable choice when:
- The balance changed little during the period, so the average and the ending figure are close.
- Only one balance sheet is available.
- You need to match a figure that someone else calculated on ending balances, such as a published ratio. Loan agreements in particular define their own tests, so follow the agreement’s definition.
Whichever basis you use, say which one when you report the figure.
Why consistency matters
The choice of basis can move a ratio as much as a real change in the business. If you calculate one year on averages and the next on ending balances, the trend may reflect the method rather than performance. The same applies between businesses: a gap between your figure and a published one may come partly or entirely from the basis. Many textbooks define these ratios with average balances, while some published figures use ending balances, so check before you compare.
Consistency matters inside combined measures too. In DuPont analysis, net profit margin multiplied by asset turnover and the equity multiplier equals return on equity only when all three use the same period and the same balances. The three parts of the cash conversion cycle should likewise all use average balances or all use ending balances. Days inventory outstanding is defined both ways in textbooks, and the two forms give different answers whenever inventory changed during the year.
Quarterly averages for seasonal businesses
A two-point average assumes the balance moved evenly through the year, which is often not true for a seasonal business. Suppose a business holds inventory of 50,000 at the start of the year, builds it to 90,000, 150,000 and 120,000 at the end of the first three quarters, and runs it back down to 50,000 by the year end. Its cost of goods sold for the year is 460,000.
The average of the opening and closing balances is 50,000, which gives inventory turnover of 9.20, or about 40 days of stock. Averaging all five balances gives (50,000 + 90,000 + 150,000 + 120,000 + 50,000) ÷ 5 = 92,000, which gives turnover of 5.00, or 73 days. The five-point average is much closer to the stock the business carried through the year.
Timing matters in the same way when a balance changes once. If the business in the earlier example bought its equipment in the last month of the year, it held about 400,000 of assets for most of the year, so the simple average of 500,000 overstates what it used.
To use a quarterly or monthly average in one of these calculators, work out the average first and enter it as both the opening and the closing balance, since the average of two equal figures is the figure itself. Other limits of single-date figures are covered in limitations of financial ratio analysis.