Welcome, in this video, we're going to begin to discuss ratios. We're going to talk about what a useful tool they can be and how you could use them. Let's start by thinking about what a ratio even is. To answer this question, I thought, well, I'll just go take a look in a dictionary. And the first answer that I came up with, it's the relative magnitude of two quantities. Now that is absolutely true. It's also not all that helpful. For example, you could think of something like the number of people in the State of Michigan. Two gallons of water in the Atlantic Ocean, that gives us the relative magnitude of two quantities, but it actually doesn't tell us anything that we want to know. So I kept looking, the next definition I found was a little more useful, it said it's a wave combining two or more pieces of information to provide further insight. That's really what we want to do with ratios, provide further insight and it is about putting together more than one piece of information, so I thought this was getting us closer. But then I started taking a look at more financially oriented definitions, and I found a definition I liked even better. A combination of items from financial statements to show their logical inter relationship. Since what we have been doing with accounting all along is trying to capture what is going on in a firm. Understanding the interrelationship between different pieces of information we capture is probably going to to help us go a long way towards providing that further insight that the other definition says we want to get. Now, when I put all this together, I decided, really, the definition I like is. It’s a tool used to help extend your understanding of a business. That’s all that a ratio is, it’s not something magic it’s a great tool but just a tool. Now you seen a few ratios already, we just haven't talked about them that much. For example, remember back when we were talking about whether we're going to to be able to fulfill all of our obligations? When we were doing our comprehensive example on that Libra of Wisdom company. We put current assets over current liabilities, and said this will give us some sense of whether we have enough assets to fulfill our liabilities. Or you might recall that we also asked ourselves a question of how much did the owners get to keep of each sale that's made. We said, well, we can put net income over revenue. That again, was a ratio. We were taking two pieces of information and combining them to get us a further insight. What percentage of revenue do our owners get to keep. Similarly, we put net income over equity to answer the question of how much value the manager created for the equity holders, dependent on how much value the equity holders had given the manager to work with to begin with. That's again combining two pieces of information to give us further insight. If I give you some value to use, can you get me a return on it or not? If so how much? So the first way you might use a ratio is to compare a firm to itself over time. You can take a look and see hey, is my liquidity going up or down? Once you can see something like that, then you can start asking yourself further questions to better understand what's going on in the firm. You could compare across firms. Here's my liquidity, here's the liquidity of another firm that I think I should be similar to. If they're different, why are they different? And what does this mean about my firm? You can compare a firm to its industry. If I work in the same industry as everybody else, I would expect my economics to be similar. So I can compute some ratios and see, are there any relationships on my financial statements. The same as the industry or different than the industry. If they're different, is that a good thing? Is that a bad thing? Should I change things? Should other people change to be more like me? Or you can compare even across industries. So you could say, right now we're in this industry and this means we're structured in certain ways. If we were to switch to that industry, what does their industry look like? Or maybe it's an investor you're just trying to decide which industry is going to give me a better return on my capital. And you might want to understand how the different industries create return on capital. The thing I wanted you to notice about all of these is, they all say you want to compare to something. A ratio in and of itself is not very useful. But if you can put it into a context where we're comparing to something to help to give us an answer to a question, then it can really provide a wonderful amount of insight. As you think about how to use ratios, it's useful to have an overall thought process of what they're useful for and why. The power of ratios is really the way they combine information to provide a greater insight into the firm's operations. That's why we're going to use a ratio, to get that combined information to create the insights. Sometimes, they're going to do this by using information off from one of the financial statements, and help us understand relationships within that statement. Often times, though, they're going to draw across the multiple statements. That way, they're going to put together information about both the current status of the firm and its value creation. By doing that, it creates insights that we can't get from any one of the statements. This gives you a good idea of how to use ratios. But what's really the most important thing to understand about using ratios? Well, you have to think. Too often, people will use a ratio in place of thinking. Their belief is that somehow the ratio replaces the need for thoughtful analysis. It's just like any other tool though, it's important that you choose the correct tool for the job you're trying to do. You understand why you're using it, you're understanding what its purpose is. If you start to mechanically think that ratios are going to give you the answer, then you are not going to think about how you're using them. At that point, you can make a mistake. If you've got a friend who thinks a hammer answers all questions, well, you know what I'm talking about. That person comes to a situation where a screwdriver would be a wonderful tool for the job. All you need to do is remove a screw so you can make some changes and put the screw back in. They start pounding away with a hammer, they might remove whatever it is they were trying to remove but they've ruined it and we're going to be able to use it going forward. Ratios are a powerful tool too, and people actually make similar mistakes with them. But if your thoughtful as you go through them, and keep in mind this process and what we get out of them. You won't be one of those people. You'll be the person that knows, should I use the hammer, should I use the screwdriver. And in fact, if you check out some of the other videos, you'll even be the person that knows how to make your own hammer or make your own screwdriver. Or whatever other tool you're going to need to be able to apply a thoughtful process to answer the questions that really matter for your company.
