Hello, welcome to this lecture today, my name is Justin like from three numbers. And in this lecture we're going to be looking at ratio analysis. And how do we interpret the results once we've actually got a balance sheet and a profit loss statement. And I'm going to actually teach you today a very simple framework in which to look at ratios and how you actually detect the health of a business. And I want you to sort of imagine yourself that you're actually a doctor. And you're actually got a toolkit with different kind of instruments that you can measure different elements of a business.
And when you actually look at these different elements that will help you to determine different kind of symptoms, or whether the business is doing well or not. So let's let's get started on these five areas. The first area we're looking at is liquidity. Okay, so liquidity is all about how quickly can convert everything into cash. Okay? And that's important because we want to understand that can we cover our debts?
And will we be able to actually continue to stay in business? And what elements of our cash flow holding us up? So the kind of ratios that you would typically look at when you're looking at liquidity would be things like the current ratio, and the quick ratio and also working capital. And so what these kind of things look at is it's looking at your current assets, and comparing it to current liabilities, and actually looking at how much cash how much accounts receivable, how many, how much inventory Do we have compared to the accounts payable and supplies that we have to pay. And then the quick ratio is slightly different to the current ratio, in that it actually takes out the inventory from the equation. So that looks at more the items that are already sold or sitting as cash.
So inventory as you know, you have to actually sell it in order to convert it into a an invoice. in which it will then turn into cash. But it's not as quick to turn into cash as an as a receivable because receivable has already been sold. And so the quick ratio is slightly different to the current ratio. And that it takes out that inventory difference with working capital. This is looking at just the difference between current assets and current liabilities as a literally kindnesses minus current liabilities.
And where this may actually help you is actually determine how much actual cash and other items do we have once we pay off all that debt do we have in our disposal? And so liquidity is really then one of the first health checks and it's looking at cash flow. The second kind of ratio analysis to look at when you're looking at a business is around profitability. And profitability is all about determining how well you're doing in terms of in terms of every time you make a sale, how much of that is actually profit. And so the kind of right sure that we want to look at things like gross profit. And you can also look at net profit.
The difference between gross profit and net profit is gross profit is sales, less cost of goods sold, which is really looking at the operational gross profit, and net profit looks at all the operating expenses taken off from your gross profit. So it's your net profit, the very bottom line of your p&l divided by your sales. And what that actually will determine is for every dollar that you sell things, how much profit Are you making, and some of the other ratios with profitability looking at return on assets and return on equity? So if you have a whole bunch of assets, now they could be property plant equipment, you could have bought, you know, purchased intangibles like patents and trademarks. You could have a whole bunch of stock and other kind of assets. In terms of your attorney, how much profit Are you actually generating in your business based on the number of assets that you have?
A lot of large organizations want to want to try to improve this ratio because they don't assets sitting around not generating profit. And so the return on assets actually helps determine how much profit you generate based on the on on the assets that you've got. And it's really a measure of an efficiency of your profitability with return on equity is slightly different, where it actually looks at all the net profit that is generated based on all of the shareholdings and other profits that you've made in the past. And so, from a shareholders perspective, this is actually looking at how much profit are we making based on all of the shareholder funds that have been contributed. And so really, then the profitability is, is more around what you sort of typically think about with business around, we're here to make a profit. And so obviously, you want to maximize profitability, and look at ways in which you can improve profitability by minimizing costs or increasing your sales price.
The next kind of ratio and and lens that you could actually look at interpreting your business is, is around its effectiveness. And what this actually looks at is, it looks at how well are we managing the collection of our customer debts, as well as the management of inventory and payment to our suppliers. And so the reason why this is important is because that the quicker you can actually turn stock over, the faster you can generate sales. And the quicker we can, we can actually click cash cash from our customers, the quicker we improve our cash flow. And obviously, the the amount of time it takes to pay suppliers. If we pay them too quickly.
It can be an indication that we're ineffective because there's an opportunity to actually extend the terms that we're actually paying suppliers by negotiation or shopping around in order to maximize the cash flow. So the kind of ratios that we look at are things like data days inventory data uncredited dice. And really these, as I mentioned before, these looking at three particular areas, it's looking at our collections and how effective we are collecting debt off our customers. It's looking at our inventory management, and how quickly can we turn over our inventory based on number of days per year. And creditors is looking at how quickly we're paying us to blogs. The next area that we should be looking at when looking at business is around leverage.
And leverage is all about debt versus equity. And so the kind of ratios that we'd be looking at when we're looking at leverage of things like debt to equity, which is looking at how much debt do we have in the business, which is like money that is borrowed off other banks or through creditors, versus how much money have we got through an equity and that's money that's raised by shareholders injecting funds into the business in order to help fund the business. And so this is an important measure of risk because The higher the level of debt in a business, the more risky it is. Now, as a rule of thumb, you want to be trying to aim for a debt of some anywhere below 60 to 65%. If it starts to get below that, if it starts to get above that level, it should be quite concerned that the business is very highly leveraged.
And the reason why this is risky, is because you have to continue to pay interest to debt holders. Whereas for equity holders, they they're relying more on capital growth of share or a dividend, and it's not set in stone, you have to pay a dividend. And the other ratio is debt to assets, which is looking at how much debt you have versus your assets. So again, both of these ratios, look at leverage and in terms of how much debt we have in our business. And the final area is shareholders ratios. And so these look at things like how much what's that price earnings ratio, in terms of the funds that the shareholders invested with?
What kind of return are they getting. And another kind of ratio could be like dividend payout, we're looking at all the profit, the net profit and versus the net profit versus the sorry, the dividends versus the net profit. And this would actually determine how much of the net profit is actually paid out as dividends. So from a shareholders perspective, if they're actually generating a lot of dividends and pay most a lot of profits in paying out as dividends, this is actually a very good thing from a shareholders perspective. And so really, it's these five lenses, their different perspectives in which to analyze a business. And you can really then at any one of these ratios, and look at it from a different perspective and determine its liquidity.
So how well is its cash flow, in terms of its profitability, how profitable is the business leverage in terms of how leveraged to the business and exposure to debt, its effectiveness in terms of how will is management, managing customers and inventory and the working cow Well, the business and then shareholder performance in terms of how profitable is it for shareholders in terms of their return on investment, the price earnings ratio and the kind of dividends that getting paid out. So I hope that's given you some perspective, on just the different ways to think about it, I wouldn't get overwhelmed with all the formulas and just the number of ratios are really just think of it into five areas. And then once you, once you segment a business into five areas, you can then pull out the relevant ratio, that would help give you the best kind of interpretation.
Okay, so anyway, that is all about ratios. You could almost do an entire course on this really, if you want to go into a lot more depth, but this from from an interaction perspective, this is just giving you a perspective. So I'll see you in the next lecture.