Why are average balance sheet amounts used in calculating the turnover ratios?

In the calculation of a turnover ratio, the numerator is an amount from an annual income statement, while the denominator is a balance sheet amount. Since a balance sheet amount is a snapshot and reflects only an instant or moment, there is an inconsistency between the numerator and the denominator.

For example, the numerator in the inventory turnover ratio is the cost of goods sold for the 365-day year, while the denominator reflects the cost of inventory for a just one moment at the end of the last day of the accounting year. To overcome this shortcoming, the denominator needs to be representative of all of the moments during the year.

When the inventory amount on last year’s balance sheet and the amount on this year’s balance sheet are the only amounts available, it is common to use the average of these two balance sheet amounts in the denominator.

Using the average of only two days can also be misleading if the company’s year ends at the low point of business activity. For example, when a company’s peak season is August through May, it is common to set the accounting year to be July1 through June 30. At June 30 its inventory will likely be at their lowest point of the whole year and will not be representative of the amounts during the months of August through May.

Learn more about Financial Ratios.

About the Author: Harold Averkamp (CPA) has worked as an accountant, consultant, and university accounting instructor for more than 25 years.

He is the author of the 2010 Master Accounting Download Package which has been praised for it's ability to simplify accounting in a way that anybody can understand.