Interpret financial statements and analyse liquidity, profitability and finance sources.

What this dot point is asking

Finance is the function that ensures a business has enough money to operate and grow, and that this money is used wisely. It starts with how a business funds itself. Sources of finance are usually classified two ways. By term, they are short term (due within twelve months, such as overdrafts, trade credit and commercial bills) or long term (mortgages, leases, debentures and equity). By origin, they are internal (generated within the business, such as retained profits or selling assets) or external (from outside, such as loans, share issues or government grants).

A central distinction is between debt and equity. Debt finance is borrowed money that must be repaid with interest; it must be serviced even when profit falls, but interest is tax deductible and the lender does not gain ownership. Equity finance is funds from owners or shareholders; it carries no repayment obligation, but it dilutes ownership and shares future profits. Gearing measures the proportion of debt to equity: high gearing increases risk because of fixed interest commitments.

Day-to-day control relies on cash flow management and budgeting. A cash flow statement tracks money coming in and going out, and a cash flow budget forecasts it so the business can spot future shortfalls and arrange finance in advance. Managing the timing of receipts and payments, for example by offering discounts for early payment or negotiating longer terms with suppliers, helps keep enough cash on hand.

Two financial statements summarise performance and position. The income statement (profit and loss statement) shows revenue minus expenses over a period, giving gross profit (sales minus cost of goods sold) and then net profit. The balance sheet shows the business's financial position at a point in time, listing assets, liabilities and owner's equity, and always balances under the accounting equation.

Ratio analysis turns these statements into meaning by comparing figures over time or against competitors. Liquidity is measured by the current ratio (current assets divided by current liabilities); a result around 2 to 1 is often seen as healthy, meaning two dollars of current assets for every dollar of current liabilities. Profitability is measured by ratios such as net profit margin (net profit divided by sales) and return on owner's equity (net profit divided by owner's equity), showing how well the business converts sales and investment into profit. Efficiency ratios, such as the expense ratio or inventory turnover, show how well assets and costs are managed.

Good financial management interprets these results to make decisions: improving liquidity by reducing stock or chasing debtors, lifting profitability by cutting expenses or raising margins, and choosing the right mix of finance to fund growth without taking on too much risk. Financial records must also be accurate and reported honestly to meet legal and ethical obligations to owners, the tax office and other stakeholders.