Welcome. Ratios are a powerful tool. And I think this course has given you the skills so that you'll be able to use them as you move forward- allowing you to contribute more to your company, helping it make better answers and better understand the choices that it has to make, the way that it operates etc. That said, given how powerful this tool is, they have also led to a bunch of common misconceptions. People know that they can do a lot with ratios and then they start to be sloppy. These misconceptions can actually be dangerous in meeting your goal of being a valuable employee in your company or a valuable contributor in your own life. So I'm going to walk you through some of my favorite misconceptions that I've heard over the years about ratios. Let's start with this idea that each ratio has one and only one name. Here's a ratio for you. Cash plus marketable securities plus accounts receivable over current liabilities. You know enough about accounting to look at this and say, "Ha! The things on the top are all things I can use to fulfill obligations. The bottom is obligations I have. This ratio must be saying am I going to be able to fulfill my obligations." You don't necessarily have to put a name on it, but people are going to want to put names on it. Well, if you take this ratio and you start looking through major finance books, what you're going to find is that a lot of them will call this the quick ratio. These are things that to pay off quickly. How much do I have that I could quickly use to do that? That's the basic idea of the name. However, you also can find it called the acid ratio or you can find it called the liquidity ratio. That's only three of the names it's called, I could give you a bunch of other ones. The point here is that for the same formula, we've got multiple names. You should be aware of this because it can stop you from having a lot of disagreements with people. For example, imagine you're talking to one of your friends and they say, "We've got to figure out how we're going to meet our obligations". And you say, "Hey, let's calculate a quick ratio", and they look at you and say, "You're an idiot. It's time for the liquidity ratio here". There's no sense in arguing over what you're going to call it, if you're both thinking of the same ratio. Now let me take you to a related misconception. Each ratio name has one, and only one formula. Let's go back to the acid ratio, we just talked about the acid ratio a few minutes ago. It had a formula that look like this. If your boss comes in and says calculate an acid ratio and they're thinking of this- hopefully this is what you'll do. However, if you take those same finance books or just google acid ratio, you might come up with a formula you just saw here or you also might find this formula. It seems to be equally common. Notice the difference here is they didn't put in accounts receivable. Is that right? Is that wrong? It really depends on the situation we're in, and I'd have to understand the situation to know which one of these I'd want to have in there to make my ratio a good tool. What I do know is, if your boss expected you to do the one at the top including accounts receivable and you didn't understand that's what they meant by acid ratio, so you did the one at the bottom and left accounts receivable out, she's not going to be very happy if that difference changes the analysis and leads her to make a bad decision. It's important when somebody uses a name for a ratio that you just confirm with them, this is how they're thinking about it. Otherwise, we could end up in a situation where we're using the same name, but we're thinking of two different formulas. Both of these are really getting at this idea of what's in a name. And it's pretty trite now to steal that old line, "Is a rose by any other name-" Blah blah blah. But really that's the point we're getting at. Don't get hung up on names here. What makes the ratio powerful is the information you put in it. So focus on what information might put it into that ratio, and that's going to make it useful for you. Alright. Let's move on to some of the other misconceptions I love to hear. The next one is, each question that you have can be answered by a specific ratio, you just need the list. I know a long long list of people who have created lists like this. They're well-meaning people. I see this every year in our MBA programs. Somebody will show up with a list that their buddy gave them saying, here's a 15 ratios if you just calculate these you're all set. On that list it will say, here's a ratio and here's the question that answers. The problem is every list like that I've seen, I can point out where well that ratio doesn't really answer that question or sure, in some situations it answers that question, but not in all situations. In fact, if we go back to our example of the quick ratio, the acid ratio, whatever you want to call it. Should accounts receivable will be in that numerator or not? Well, it depends on the situation and my list isn't going to capture that for me. I wish it was true that I could just give you a list. I would have made it a PDF hand out and put it in this course to give it to you, but that's just not true. It's just wishful thinking. Now, let's move on to another common myth. I see this one at a lot of companies. There'll be a certain set of ratios that the company or a particular manager within the company really likes, and often when they start a project they'll have some junior person calculate all those ratios. It doesn't matter what the project's about, they just think this set of ratio should be calculated, and once we have it we can answer any question that comes up about the company. They've become very reliant on that set of ratios, they don't think outside of it and often they'll force an answer based on those ratios when more thoughtful analysis would have led to something else, probably more useful as well. Now, if your boss has a set of ratios and they want you to calculate them, by all means calculate them. Just make sure that you're also thoughtful about what else could we be doing as we run into different questions. Moving on to our next myth, it's decided that you should always use average balance sheet numbers in any ratio that you're going to calculate, or it's corollary, you should never average balance sheet numbers if you're going to calculate a ratio. In the first part, people say use average because you have some amount of the item at the beginning of the year and at the end of the year and the average gives you what you had on average throughout the year. And the second one, people will say, no I really want to know at a given point in time. I once literally had two executives almost come to blows- to the point where other people had to step between them in an Exec-Ed class because they were so angry that one of them had averaged and the other one hadn't averaged and they each insisted they were right because their company did it this way. Once we get everybody calmed down, we realized that their companies were using the ratios in different ways and each company was right for the question they were trying to answer, their approach was correct. There is no replacing that idea of thinking, and when people try to set a hard and fast rule like this, that's what they're trying to do. Alright. How about another way that people try to avoid thinking? Often people will say, well, I can take a ratio and that's going to make me comparable across some attributes that are very different. Most commonly, this is for size- what well size deflate, now everything is comparable. But in all honesty, if a really big firm operates their company very differently because of the scale they have, a ratio isn't going to take away the impact of that. You're kidding yourself if you think size adjusting is going to get you there relative to the small firm who has to operate differently. Industry is another one. People will say well, I can compare ratios across the industries and then the industry doesn't matter. So if the ratio is a certain amount in one industry and it's lower in another industry, the high industry is doing that ratio better. Well, it's really just telling us that those two industries are different. It's helping us understand how, but it's not making them comparable across the industries. I could keep going on. I can just tell you lots of people think once I've done a ratio, I can stop thinking about all this other context. It's not true at all. In fact, you want to do the ratio to help you understand the importance of that context. And let's move on to my favorite, and this will be our final one as well. Ratios can be used in place of understanding accounting. Now, you might think that I'm biased here or I want to tell you, no that's not true because it would kill my job. But there's actually all sorts of things I could teach you other than intro accounting and I'd love to teach you those things. I'd love that you had the time to do them. It would actually make my life a lot easier. We could do one or two classes on ratios then we can move on to talking about how businesses work, how we're going to understand them etc. But the fact of the matter is, if you don't understand accounting, you're not going to understand the accounting number that you're putting into the ratio. Which means you're not going to understand what the ratio is telling you. There's no way to get around it. The accounting is a big part of what makes the ratio so useful and your understanding of accounting is the skill that's going to allow you to use ratios. Alright. I've warned you a whole bunch about ratios. I hope you spend more time though on the other videos. The ones that really help you understand how to use ratios to do a better job at whatever it is you're trying to accomplish in life.
