The Term ‘Average’ Explained in Terms of Accounting, Business, and Finance

What does average mean?

Simply put, average is the answer you get when adding two or more numbers together and dividing the sum by the total of numbers you added together.

The term ‘average’ is used in different ways to indicate the average of a specific aspect in accounting, business, and finance.

The article aims to briefly explain the following usages of the term:

• Average age of inventory
• Average annual growth rate (AAGR)
• Average inventory
• Average collection period
• Average cost method
• Average daily balance method
• Average daily trading volume (ADTV)
• Average outstanding balance
• Average return
• Average selling price (ASP)

What is the average age of inventory?

The average age of inventory refers to the average number of days that elapse before a business sells of its inventory.

It is an important working capital metric to determine the efficiency of a business’s sales. The average age of inventory is also called days’ inventory on hand (DOH) or days’ sales in inventory (DSI).

The metric is calculated as follows:

Average age of inventory = (Average inventory balance/Cost of goods sold (COGS)) x 365

Where:

• Average inventory balance is the average of the opening and closing inventory balances of a specific financial period, such as a quarter or financial year.
• COGS refers to costs directly associated with the manufacturing of goods and/or the rendering of services.

The average age of inventory is an indication of how quickly a company is turning over its inventory.

Typically, a high inventory turnover signals that a business is efficiently selling its inventory. Conversely, a low inventory turnover indicates that a business is grappling with the problem of low sales.

What is the average annual growth rate (AAGR)

The average annual growth rate (AAGR) is the average annual increase in the value of an asset, individual investment, portfolio, the revenue of a business, or cash flow.

It is calculated by taking the numerical mean of a series of year-on-year returns, excluding the effects of compounding.

Put differently, AAGR is the accepted method to determine average returns of investments over numerous periods of time on an annualised basis. However, the time periods should all be of the same length, for example, years, quarters, months, or weeks. A combination of periods of different durations is not allowed.

The formula the calculate the AAGR is:

AAGR = (GR_a + GR_b + … + GR_n)/N

Where:

GR_a = Growth rate in period a

GR_b = Growth rate in period b

GR_n = Growth rate in period n

N = Number of payments

Example of AAGR calculation

Company Try Again reported the following revenues for the past 5 financial years:

Year 1: R320 000

Year 2: R350 000

Year 3: R390 000

Year 4: R420 000

Year 5: R450 000

To calculate the growth rate percentage for each year, the following basic formula is used:

Growth rate percentage = ((EV/BV) – 1) x 100%

Where:

• EV = Ending value
• BV = Beginning value

The growth rate percentages for each of the years are as follows:

Year 1: 0, because there is no previous period of time

Year 2: ((350 000/320 000) – 1) x 100% = 9.4%

Year 3: ((390 000/350 000) – 1) x 100% = 11.4%

Year 4: ((420 000/390 000) – 1) x 100% = 7.7%

Year 5: ((450 000/420 000) – 1) x 100% = 7.1%

Next, the AAGR is calculated as follows:

AAGR = (9.4% + 11.4% + 7.7% + 7.1%)/5

= 35.6%/5

= 7.12%

Thus, the annual average growth rate for the company Try Again for the past 5 years is 7.12%.

What is the average inventory?

The average inventory is the mean value of a business’s inventory during a specified time period. The mean value may differ from the median value.

Put differently, the average inventory is a measurement of inventory averaged over two or more accounting periods. An accounting period can be either a financial year, quarter, month, or week.

Average inventory is calculated by using the following formula:

Average inventory = (Current inventory + Previous inventory)/Number of periods

For instance, company Perseverance has a current inventory of R20 000 and recorded the following inventory figures for the previous three months:

Month 1: R18 000

Month 2: R16 000

Month 3: R24 000

The average inventory of company Perseverance for the quarter will be calculated as follows:

Average inventory = (R20 000 + R18 000 + R16 000 + R24 000)/4

= R78 000/4

= R19 500

Usually, average inventory is used to compare sales or revenue.

What is the average collection period?

The average collection period refers to the amount of time it takes, on average, for a business to collect its accounts receivable (AR), also referred to as receivables.

Accounts receivable (AR) is the amount of money due to a business for goods delivered or used and/or services rendered but not yet paid for by customers.

Put another way, AR refers to the money owed to a business by its debtors for goods and/or services purchased on credit.

The average collection period is an important indicator for businesses to ensure they have enough cash available to cover their short-term financial obligations.

The formula for the average collection period is as follows:

Average collection period = (Accounts receivable balance/Total net sales) x 365

Where:

• Accounts receivable balance refers to the AR balance at the end of a specific accounting period.
• Total net sales are the net sales for a specific accounting period.

Example of the average collection period of a business:

Let us assume that business Good Times reported an accounts receivable balance of R75 000 for the previous financial year. Its net sales were R450 000.

The average collection period of business Good Times will be calculated as follows:

Average collection period = (R75 000/R450 000) x 365 = 60.8

This means that the average collection period of business Good Times is about 61 days. It is a quite high figure, considering that most businesses aim to collect payments from debtors within 30 days.

The lower the collection period, the faster a business collects payments from debtors.

What is the average cost method?

The average cost method also called the weighted average cost (WAC) method, is a method used in accounting to calculate the amount involved in the cost of goods sold (COGS) and inventory.

Simply put, this method allocates a cost to items in inventory by dividing the total cost of goods purchased (or produced) during a specific accounting period by the total number of items purchased or produced.

The average cost method is one of three methods that are used to determine the value of inventory. The two other methods are:

• FIFO (first-in-first out).
• LIFO (last-in-first out).

Example of the average cost method:

Company Bushward sells camping gear. The following information for the first quarter of the financial year is available from its inventory ledger:

During the first quarter company, Bushward purchased 137 items of camping gear for a total cost of R220 500.

To obtain the average cost per item, the total cost (R220 500) is divided by the total number of items purchased (137). Thus, the average cost per item = R1 609.49.

Let us say the company sold 70 items during the first quarter. The cost of goods sold (COGS) will be recorded as 70 items sold at an average cost of R1 609.49, amounting to R112 664.30.

The cost of goods available for sale at the end of the first quarter will be the remaining 67 items, recorded at R107 835,85 (70 x R1 609.49).

What is the average daily balance method?

The average daily balance (ADB) method is most commonly used by credit card companies to calculate interest charges, also called financing charges, on outstanding balances owed by borrowers at the end of each day.

Calculating the interest charges according to the daily average balance method comprises three components, namely:

• The credit card’s finance charge referred to as the annual percentage rate (APR).
• The billing period of the card.
• The outstanding balance of the account at the end of each day of the billing period.

The interest charges are calculated as follows:

Let us say Lucky Luke has a credit card with a credit card company that charges an APR of 18%. In addition, the credit card has a 30-day billing period, and there was a balance of R2 350 at the beginning of the new billing period (cycle).

Lucky Luke purchased goods of R250 on the tenth day of the billing period and made a payment of R300 on the 21^st day of the billing cycle to reduce the outstanding balance.

Considering the information above, the balances for each day in the billing period will look as follows:

• Day 1 – 9: R2 350
• Day 10 – 20: R2 600 (R2 350 + R250)
• Day 21 – 30: R2 300 (R2 600 – R300)

Thus, the calculation of the average daily balance for the specific billing period will look as follows:

[(R2 350 x 9 days) + (R2 600 x 11 days) + (R2 300 x 10 days)]/30 days = R2 425

Furthermore, the financing charges related to Lucky Luke’s credit card for the specific billing period can also be determined by applying the following formula:

(APR x Number of days in the billing period x Average daily balance)/365

= (18% x 30 days x R2 425)/365

= R35.87

Besides the average daily balance method, two other common can be used to calculate the interest owed on the balances of credit cards, namely:

• The adjusted balance method: Interest charges are calculated on the outstanding balances at the end of a billing period after credits and debits have been posted to the credit card account.
• The previous balance method: Finance charges are calculated on the balance owed at the beginning of the previous billing cycle.

What is the average daily trading volume (ADTV)?

The average daily trading volume (ADTV) is a technical indicator that shows how many shares of a specific company, on average, are traded during a single trading day.

This technical indicator can be calculated for any period of time, for instance, five days, ten days, etc. However, the ADTV is commonly measured for a period of 20 or 30 days.

The average daily trading volume is calculated as follows:

Step 1: Add up the total trading volume of stock for each day over a specific timeframe.

Step 2: Divide the total obtained in step 1 by the number of days in the timeframe.

For example:

The trading volumes of the shares of the company Straight Forward for the past 5 trading days are as follows:

• Day 1: 100 000
• Day 2: 150 000
• Day 3: 70 000
• Day 4: 95 000
• Day 5: 110 000

The total of the shares traded for the 5 days is 525 000 shares.

Thus, the ADTV of the shares of the company Straight Forward for the past 5 trading days is 105 shares (525 000 shares/5 days).

The ADTV is an important technical indicator for investors and analysts because it indicates, inter alia, market conditions such as:

• The overall level of interest in the shares of a company.
• Price levels, signifying support or resistance for a specific share.
• Liquidity in the trading of a company’s shares.

What is the average outstanding balance?

Simply put, the average outstanding balance is the amount owed by a borrower on any debt that charges interest, averaged over a specific period of time. It includes the balances after the last payments and any interest accrued over time.

Generally, the average outstanding balance is calculated daily, adding up the balance for each day of a statement period and dividing it by the number of days in the specific period. Although, the outstanding balance can also be calculated on a monthly, quarterly, or yearly basis.

The average outstanding balance, also called the current balance, comprises only an average amount that a borrower has not settled or savings that a client has not withdrawn over a specific period.

The balance serves different purposes, amongst others, the following:

• A method utilised by credit issuers to calculate the outstanding loan portfolio.
• Outstanding balances are reported by credit issuers to consumer credit bureaus to use in credit scoring rates.
• Used as an instrument to evaluate interest on debt.
• Large outstanding balances can be a signal of financial problems for both borrowers and lenders.

What is average return?

The average return is the simple mathematical average of a series of returns generated and accrued over a determined period of time. It is calculated in the same way as a simple average.

It is calculated by adding the amounts of the returns together in one sum, then the sum is divided by the number of returns in the set. Hence, the formula to determine the average return looks as follows:

Average return = Sum of returns/Number of returns

An example of average return:

Let us assume an investment generates the following returns annually over a period of 10 years:

• Year 1: 9%
• Year 2: 10%
• Year 3: 8%
• Year 4: 12%
• Year 5: 11%
• Year 6: 7%
• Year 7: 6%
• Year 8: 4%
• Year 9: 4%
• Year 10: 6%

The average return of the investment for the 10 years looks as follows:

Average return = (9% + 10% + 8% + 12% + 11% +7% + 6% + 4% + 4% + 6%)/10

= 67%/10

= 6.7%

What is the average selling price (ASP)?

The average selling price (ASP) refers to the price that a product or service in a specific category is sold for. It is applied across different markets and distribution channels.

The average selling price of a product or service is calculated by dividing the total revenue earned from the product or service by the number of products or services sold.

Typically, the average selling price is used as a benchmark for a particular product, enabling other manufacturers and suppliers to determine prices for their own products.

Example of the ASP calculation:

The record of sales for the past financial year of a business that distributes sportswear show the following sales:

• 9 500 items at R230 each.
• 12 000 items at R200 each.
• 18 000 items at R170 each.

The total amount of revenue earned by the business is

• 9 500 x R230 = R 2 185 000
• 12 000 x R200 = R2 400 000
• 18 000 x R170 = R3 060 000

Total amount of revenue generated: R2 185 000 + R2 400 000 + R3 060 000 = R7 645 000

• Number of items sold

9 500 + 12 000 + 18 000 = 39 500

• Calculation of the average selling price

Average selling price = R7 645 000/39 500 items

= R193.54