Month: April 2020

Organizational patterns are inspired in large part by the principles of the software pattern community, that in turn takes it cues from Christopher Alexander’s work on patterns of the built world. Organizational patterns also have roots in Kroeber’s classic anthropological texts on the patterns that underlie culture and society. They in turn have provided inspiration for the Agile software development movement, and for the creation of parts of Scrum and of Extreme Programming in particular.

Principles of discovery and use

Like other patterns, organizational patterns aren’t created or invented: they are discovered (or “mined”) from empirical observation. The early work on organizational patterns at Bell Laboratories focused on extracting patterns from social network analysis. That research used empirical role-playing techniques to gather information about the structure of relationships in the subject organization. These structures were analyzed for recurring patterns across organization and their contribution to achieving organizational goals. The recurring successful structures were written up in pattern form to describe their tradeoffs and detailed design decisions (forces), the context in which they apply, along with a generic description of the solution.

Patterns provide an incremental path to organizational improvement. The pattern style of building something (in this case, an organization) is:

• Find the weakest part of your organization
• Find a pattern that is likely to strengthen it
• Apply the pattern
• Measure the improvement or degradation
• If the pattern improved things, go to step 1 and find the next improvement; otherwise, undo the pattern and try an alternative.

As with Alexander-style patterns of software architecture, organizational patterns can be organized into pattern languages: collections of patterns that build on each other.

A pattern language can suggest the patterns to be applied for a known set of working patterns that are present.

Organizational designs fall into two categories, traditional and contemporary. Traditional designs include simple structure, functional structure, and divisional structure. Contemporary designs would include team structure, matrix structure, project structure, boundaryless organization, and the learning organization. I am going to define and discuss each design in order to give an understanding of the organizational design concept.

I. Traditional Designs

1. Simple Structure

A simple structure is defined as a design with low departmentalization, wide spans of control, centralized authority, and little formalization. This type of design is very common in small start up businesses. For example in a business with few employees the owner tends to be the manager and controls all of the functions of the business. Often employees work in all parts of the business and don’t just focus on one job creating little if any departmentalization. In this type of design there are usually no standardized policies and procedures. When the company begins to expand then the structure tends to become more complex and grows out of the simple structure.

2. Functional Structure

A functional structure is defined as a design that groups similar or related occupational specialties together. It is the functional approach to departmentalization applied to the entire organization.

3. Divisional Structure

A divisional structure is made up of separate, semi-autonomous units or divisions. Within one corporation there may be many different divisions and each division has its own goals to accomplish. A manager oversees their division and is completely responsible for the success or failure of the division. This gets managers to focus more on results knowing that they will be held accountable for them.

II. Contemporary Designs

1. Team Structure

A team structure is a design in which an organization is made up of teams, and each team works towards a common goal. Since the organization is made up of groups to perform the functions of the company, teams must perform well because they are held accountable for their performance. In a team structured organization there is no hierarchy or chain of command. Therefore, teams can work the way they want to, and figure out the most effective and efficient way to perform their tasks. Teams are given the power to be as innovative as they want. Some teams may have a group leader who is in charge of the group.

2. Matrix Structure

A matrix structure is one that assigns specialists from different functional departments to work on one or more projects. In an organization there may be different projects going on at once. Each specific project is assigned a project manager and he has the duty of allocating all the resources needed to accomplish the project. In a matrix structure those resources include the different functions of the company such as operations, accounting, sales, marketing, engineering, and human resources. Basically the project manager has to gather specialists from each function in order to work on a project, and complete it successfully. In this structure there are two managers, the project manager and the department or functional manager.

3. Project Structure

A project structure is an organizational structure in which employees continuously work on projects. This is like the matrix structure; however when the project ends the employees don’t go back their departments. They continuously work on projects in a team like structure. Each team has the necessary employees to successfully complete the project. Each employee brings his or her specialized skill to the team. Once the project is finished then the team moves on to the next project.

4. Autonomous Internal Units

Some large organizations have adopted this type of structure. That is, the organization is comprised of many independent decentralized business units, each with its own products, clients, competitors, and profit goals. There is no centralized control or resource allocation.

5. Boudaryless Organization

A boundaryless organization is one in which its design is not defined by, or limited to, the horizontal, vertical, or external boundaries imposed by a predefined structure. In other words it is an unstructured design. This structure is much more flexible because there is no boundaries to deal with such as chain of command, departmentalization, and organizational hierarchy. Instead of having departments, companies have used the team approach. In order to eliminate boundaries managers may use virtual, modular, or network organizational structures. In a virtual organization work is outsourced when necessary. There are a small number of permanent employees, however specialists are hired when a situation arises. Examples of this would be subcontractors or freelancers. A modular organization is one in which manufacturing is the business. This type of organization has work done outside of the company from different suppliers. Each supplier produces a specific piece of the final product. When all the pieces are done, the organization then assembles the final product. A network organization is one in which companies outsource their major business functions in order to focus more on what they are in business to do.

6. Learning Organization

A learning organization is defined as an organization that has developed the capacity to continuously learn, adapt, and change. In order to have a learning organization a company must have very knowledgeable employees who are able to share their knowledge with others and be able to apply it in a work environment. The learning organization must also have a strong organizational culture where all employees have a common goal and are willing to work together through sharing knowledge and information. A learning organization must have a team design and great leadership. Learning organizations that are innovative and knowledgeable create leverage over competitors.

Displacement of Objectives

Rules originally devised to achieve organizational goals at each level become an end in themselves independent of organizational goals. Thompson calls such bureaucratic behavior as a process of “inversion of ends and means”. When individuals holding office at lower levels pursue personal objectives or objectives of sub units, the overall objectives of the organization may be neglected. When objectives get so displaced it is often difficult for managers at higher levels or even for the other constituents of the organizations such as consumers and stock holders to seek redress.

Compartmentalization of Activities

Specialization and division of labor are encouraged in bureaucracies to improve organization effectiveness. But the resulting categorization breeds the notion of watertight compartmentalization of jobs, restricting people from performing tasks that they are capable of performing. For example, a pipe fitter can install a pump, but is prohibited from making the electrical connection. It would also encourage a tendency to preserving existing jobs even when they become redundant. The sequential flow of work may usually have an element of idle time at almost every level. The bickering over respective jurisdictions based on specialization and categorization may also often induce dysfunctional conflict in the place of coordination and cooperation among various submits of an organizations.

Bureaucracies, particularly in large complex organizations, may have unintended consequences which are often referred to as dysfunctional aspects of bureaucracy. For example, A Commercial real estate or shopping centers electric cabling plan or oceanfront luxury condos layouts require a complex planning. Over the years, there has been much disenchantment with the functioning of bureaucracies which created many antagonists of bureaucracy who prophesied about its gradual demise. The skeptics optimism however, did not fructify. None could propound workable alternatives.

As a result, bureaucracies survived notwithstanding the myriad dysfunctional aspects. It is not possible here to list all the dysfunctional functions caused by what Thompson calls as ‘bureaucratic’ behavior. There is also no agreement on whether all these are really counterproductive, because some of them at least are perceived at times as disguised blessing. The more prominent among the dysfunctional aspects include the following: 

• Rigidity
• Impersonality
• Displacement of Objectives
• Compartmentalization of Activities
• Empire building
• Red Tape

Rigidity
Critics of bureaucracy argue that rules are often and inflexible, encouraging status quoism and breeding resistance to change. Compliance with rules may provide the cover to avoid responsibility for failures. 

Impersonality
Bureaucracies emphasise mechanical way of doing things, giving primacy to organizational rules and regulations than individual’s needs and emotions. Contractual obligations receive primacy, relegating human relations to a back seat.

The foregoing discussion is based on Max Weber’s description of an ideal (normative) pattern of organization. It is difficult to distinguish precisely how the functioning of organization differs from the ideal. It can nevertheless be said that all organizations have some or all of these features and the difference between one organization and the other is one of degree alone.

Functional Aspects 

Some of the principal, prescriptive, normative functions that bureaucracies serve have positive significant to organizations. Whether and to what extent these positive features really obtain in an organization depends on actual practice which often falls short of expectations. Subject to this limitation the following can be considered as the functional aspects of an ‘ideal’ bureaucracy:

1. Specialization
2. Structure
3. Preitabiliy and Stability
4. Rationality
5. Democracy

Management process is a process of setting goals, planning and/or controlling the organizing and leading the execution of any type of activity, such as:

• A project (project management process) or
• A process (process management process, sometimes referred to as the process performance measurement and management system).

An organization’s senior management is responsible for carrying out its management process. However, this is not always the case for all management processes, for example, it is the responsibility of the project manager to carry out a project management process.

Nature of Management Process

Management is a process which brings the scarce human and material resources together and motivates people for the achievement of objectives of the organization. Management is not a onetime act but an on-going series of interrelated activities. The sum total of these activities is known as management process. It consists of a set of interrelated operations or functions necessary to achieve desired organizational goals. A process is a systematic way of doing things. It is concerned with conversion of inputs into outputs. An analysis of management process will enable us to know the functions which managers perform.

Features of Management Process

1. Social Process

The entire management process is regarded as a social process as the success of all organizational efforts depends upon the willing co-operation of people. Managers guide, direct, influence and control the actions of others to achieve stated goals. Even people outside the organization are influenced by the actions of managers.

2. Continuous Process

The process of management is on-going and continuous. Managers continuously take up one or the other function. Management cycle is repeated over and over again, each managerial function is viewed as a sub-process of total management process.

3. Universal

Management functions are universal in the sense that a manager has to perform them irrespective of the size and nature of the organization. Each manager performs the same functions regardless of his rank or position in the organization. Even in a non-business organization managerial functions are the same.

4. Iterative

Managerial functions are contained within each other the performance of the next function does not start only when the earlier function is finished. Various functions are taken together. For example, planning, organizing, directing and controlling may occur within staffing function. Similarly, organizing may require planning, directing and controlling. So all functions can be thought of as sub-functions of each other.

5. Composite

All managerial functions are composite and integrated. There cannot be any sequence which can be strictly followed for performing various functions. The sequential concept may be true in a newly started business where functions may follow a particular sequence but the same will not apply to a going concern. Any function may be taken up first or many functions may be taken up at the same time.

Four Functions of Management Process: Planning, Organizing, Leading, Controlling

Functions of management is a systematic way of doing things. Management is a process to emphasize that all managers, irrespective of their aptitude or skill, engage in some inter-related functions to achieve their desired goals.

Planning, organizing, leading, and controlling are the 4 functions of management;  which work as a continuous process. First; managers must set a plan, then organize resources according to the plan, lead employees to work towards the plan, and finally, control everything by monitoring and measuring the effectiveness of the plan.

Management process/functions involve 4 basic activities

Four Functions of Management Process

1. Planning and Decision Making: Determining Courses of Action

Looking ahead into the future and predict possible trends or occurrences which are likely to influence the working situation is the most vital quality as well as the job of a manager.

Planning means setting an organization’s goal and deciding how best to achieve them. Planning is decision making, regarding the goals and setting the future course of action from a set of alternatives to reach them.

The plan helps to maintain managerial effectiveness as it works as a guide for the personnel for future activities. Selecting goals as well as the paths to achieve them is what planning involves.

Planning involves selecting missions and objectives and the actions to achieve them, it requires decision-making or choosing future courses of action from among alternatives.

In short, planning means determining what the organization’s position and the situation should be at some time in the future and decide how best to bring about that situation.

Planning helps maintain managerial effectiveness by guiding future activities.

For a manager, planning and decision-making require an ability to foresee, to visualize, and to look ahead purposefully.

2. Organizing: Coordinating Activities and Resources

Organizing can be defined as the process by which the established plans are moved closer to realization.

Once a manager set goals and develops plans, his next managerial function is organizing human resource and other resources that are identified as necessary by the plan to reach the goal.

Organizing involves determining how activities and resources are to be assembled and coordinated.

The organization can also be defined as an intentionally formalized structure of positions or roles for people to fill in an organization.

Organizing produces a structure of relationships in an organization and it is through these structured relationships that plans are pursued.

Organizing, then, is that part of managing which involves: establishing an intentional structure of roles for people to fill in the organization.

It is intentional in the sense of making sure that all the tasks necessary to accomplish goals are assigned to people who can do the best.

The purpose of an organization structure is to create an environment for the best human performance.

The structure must define the task to be done. The rules so established must also be designed in light of the abilities and motivations of the people available.

Staffing is related to organizing and it involves filling and keeping filled, the positions in the organization structure.

This can be done by determining the positions to be filled, identifying the requirement of manpower, filling the vacancies and training employees so that the assigned tasks are accomplished effectively and efficiently.

The managerial functions of promotion, demotion, discharge, dismissal, transfer, etc.  Are also included with the broad task “staffing.” staffing ensures the placement of the right person in the right position.

Organizing is deciding where decisions will be made, who will do what jobs and tasks, who will work for whom, and how resources will assemble.

3. Leading: Managing, Motivating and Directing People

The third basic managerial function is leading it is the skills of influencing people for a particular purpose or reason. Leading is considered to be the most important and challenging of all managerial activities.

Leading is influencing or prompting the member of the organization to work together with the interest of the organization.

Creating a positive attitude towards the work and goals among the members of the organization is called leading. It is required as it helps to serve the objective of effectiveness and efficiency by changing the behavior of the employees.

Leading involves several deferment processes and activates.

The functions of direction, motivation, communication, and coordination are considered a part of the leading processor system.

Coordinating is also essential in leading.

Most authors do not consider it a separate function of management.

Rather they regard coordinating as the essence of managership for achieving harmony among individual efforts towards accomplishing group targets.

Motivating is an essential quality for leading. Motivating is the function of the management process of influencing people’s behavior based on the knowledge of what cause and channel sustain human behavior in a particular committed direction.

Efficient managers need to be effective leaders.

Since leadership implies fellowship and people tend to follow those who offer a means of satisfying their own needs, hopes and aspirations, understandably, leading involves motivation leadership styles and approaches and communication.

4. Controlling: Monitoring and Evaluating Activities

Monitoring the organizational progress toward goal fulfillment is called controlling. Monitoring progress is essential to ensure the achievement of organizational goals.

Controlling is measuring, comparing, finding deviation and correcting the organizational activities which are performed for achieving the goals or objectives. Controlling consists of activities, like; measuring the performance, comparing with the existing standard and finding the deviations, and correcting the deviations.

Control activities generally relate to the measurement of achievement or results of actions that were taken to attain the goal.

Some means of controlling, like the budget for expenses, inspection records, and the record of labor hours lost, are generally familiar. Each measure also shows whether plans are working out.

If deviations persist, correction is indicated. Whenever results are found to differ from the planned action, persons responsible are to be identified and necessary actions are to be taken to improve performance.

Thus outcomes are controlled by controlling what people do. Controlling is the last but not the least important management function process.

It is rightly said, “planning without controlling is useless”. In short, we can say the controlling enables the accomplishment of the plan.

All the management functions of its process are inter-related and cannot be skipped.

The management process designs and maintains an environment in which personnel’s, working together in groups, accomplish efficiently selected aims.

All managers carry out the main functions of management; planning, organizing, staffing, leading and controlling. But depending on the skills and position on an organizational level, the time and labor spent in each function will differ.

It is important for managers to understand this aspect of the business environment because it can affect their firm and how it should be run. No business is insulated from the outside environment.  Things like political decisions, for example, can have a huge impact on a firm by changing tax laws or regulatory regimes. As another example, the managers must be aware of things like new competitors entering their market.  Clearly, managers would need to be aware of these sorts of changes.

A Manager is the person responsible for planning and directing the work of a group of individuals, monitoring their work, and taking corrective action when necessary. For many people, this is their first step into a management career.

Managers may direct workers directly or they may direct several supervisors who direct the workers. The manager must be familiar with the work of all the groups he/she supervises, but does not need to be the best in any or all of the areas. It is more important for the manager to know how to manage the workers than to know how to do their work well.

A manager may have the power to hire or fire employees or to promote them. In larger companies, a manager may only recommends such action to the next level of management. The manager has the authority to change the work assignments of team members.

One of management main task is to keep the company alive and as resilient as possible. Understanding external environmental components are key to survive. What if a heavy rain is coming down and the sewage cannot handle it. It could mean that operations are forced to stop due to lack of energy or other water problems. If management takes these external environmental components into account, it will certainly enhance it’s ability to continue or to start up as quickly as possible. In this way, operations can continue and the company stays focused on their core activities.  And if they enlarge this thinking also for the well being of their employees, than they are truly building resilient and sustainable surroundings.

1. Internal Environment of Organization

Forces or conditions or surroundings within the boundary of the organization are the elements of the internal environment of the organization.

The internal environment generally consists of those elements that exist within or inside the organization such as physical resources, financial resources, human resources, information resources, technological resources, organization’s goodwill, corporate culture and the like.

The internal environment includes everything within the boundaries of the organization.

Some of these are tangible, such as the physical facilities, the plant capacity technology, proprietary technology or know-how; some are intangible, such as information processing and communication capabilities, reward and task structure, performance expectations, power structure management capability and dynamics of the organization’s culture.

Based on those resources, the organization can create and deliver value to the customer. This value is fundamental to defining the organization’s purpose, and the premise on which it seeks to be profitable.

Are we adding value by research and development or by customer service, or by prompt delivery or by cutting any intermediary which reduces the customers’ costs?

Organizations build capabilities over a long time. They consistently invest in some areas so that they can build strong competitive businesses based on the uniqueness they have created.

The manager’s response to the external environment would depend upon the availability and the configuration of resource deployment within the organization.

The deployment of resources is a key managerial responsibility.

Top management is vested with the responsibility of allocating resources between the ongoing operations/activities and also with future operations which are of strategic nature, that is they might yield returns in some future time which require resources now to be nurtured and have some associated risks. The top management has to balance the conflicting demands of both as resources are always finite.

For example, General Electric is an aggressive innovator and marketer who has been ruthless in its approach to changing proactively as well as reactively to sustain its competitive positions in the respective industries. This implies that over the years General Electric has invested in developing those capabilities, systems, and processes that enable it to respond.

Elements of internal environment are

• Owners and Shareholders.
• Board of Directors.
• Employees
• Organizational Culture.
• Resources of the Organization.
• Organization’s image/goodwill.

The internal environment consists mainly of the organization’s owners, the board of directors, employees and culture.

(i) Owners and Shareholders

Owners are people who invested in the company and have property rights and claims on the organization. Owners can be an individual or group of persons who started the company; or who bought a share of the company in the share market.

They have the right to change the company’s policy at any time.

Owners of an organization may be an individual in the case of sole proprietorship business, partners in a partnership firm, shareholders or stockholders in a limited company or members in a cooperative society. In public enterprises, the government of the country is the owner.

Whoever the owners, they are an integral part of the organization’s internal environment. Owners play an important role in influencing the affairs of the business. This is the reason why managers should take more care of the owners of their organizations.

(ii) Board of Directors

The board of directors is the governing body of the company who is elected by stockholders, and they are given the responsibility for overseeing a firm’s top managers such as the general manager.

(iii) Employees

Employees or the workforce, the most important element of an organization’s internal environment, which performs the tasks of the administration. Individual employees and also the labor unions they join are important parts of the internal environment.

If managed properly they can positively change the organization’s policy. But ill-management of the workforce could lead to a catastrophic situation for the company.

(iv) Organizational Culture

Organizational culture is the collective behavior of members of an organization and the values, visions, beliefs, habits that they attach to their actions.

An organization’s culture plays a major role in shaping its success because the culture is an important determinant of how well their organization will perform.

As the foundation of the organization’s internal environment, it plays a major role in shaping managerial behavior.

An organization’s culture is viewed as the foundation of its internal environment. Organizational culture (or corporate culture) significantly influences employee behavior.

Culture is important to every employee including managers who work in the organization.

A strong culture helps a firm achieve its goals better than a firm having a weak culture. Culture in an organization develops and ‘blossoms’ over many years, starting from the practices of the founder(s).

Since culture is an important internal environmental concern for an organization, managers need to understand its influence on organizational activities.

(v) Resources of the Organization

An organization s resources can be discussed under five broad heads: physical resources, human resources; financial resources, informational resources, and technological resources. Physical resources include land and buildings, warehouses, all kinds of materials, equipment and machinery.

Examples are office buildings, computers, furniture, fans, and air conditioners.

Human resources include all employees of the organization from the top level to the lowest level of the organization. Examples are teachers in a university, marketing executives in a manufacturing company, and manual workers in a factory.

Financial resources include capital used for financing the operations of the organization including working capital. Examples are investment by owners, profits, reserve funds, and revenues received out of a sale. Informational resources encompass ‘usable data needed to make effective decisions.

Examples are sales forecasts, price lists from suppliers, market-related data, employee profile, and production reports.

(vi) Organization’s image/goodwill

The reputation of an organization is a very valuable intangible asset. High reputation or goodwill develops a favorable image of the organization in the minds of the public (so to say, in the minds of the customers).

‘No- reputation’ cannot create any positive image. A negative image destroys the organization’s efforts to attract customers in a competitive world.

The internal environment of an organization consists of the conditions and forces that exist within the organization.

Internal environment {sometimes called micro-environment) portrays an organization’s ‘in-house’ situations.

An organization has full control over these situations. Unlike the external environment, firms can directly control the internal environment.

Internal environment includes various internal factors of the organization such as resources, owners/shareholders, a board of directors, employees and trade union, goodwill, and corporate culture. These factors are detailed out below.

2. External Environment of Organization: Factors Outside of Organization’s Scope

Factors outside or organization are the elements of the external environment. The organization has no control over how the external environment elements will shape up.

The external environment embraces all general environmental factors and an organization’s specific industry-related factors. The general environmental factors include those factors that are common ir\ nature and generally affect all organizations.

Because of their general nature, an individual organization alone may not be able to substantially control their influence on its business operations.

Managers have to continuously read signals from the external environment to spot emerging opportunities and threats. The external environment presents opportunities for growth leadership, and market dominance, it also poses the threat of obsolescence for products, technology, and markets.

While one section of an organization faces opportunities, another faces threats from a similar environment, perhaps because there is differentiation in their respective resources, capabilities and entrenched positions within the industry.

For example, the burgeoning mobile telephone market in India provides enormous opportunities for different types of organizations from handset manufacturers, content developers, application developers, mobile signal tower manufacturers, to service providers.

At the same time, it poses a threat to the fixed-line telephone business which for a long time, has been the monopoly of public sector enterprises.

The increasing demand for telecommunication services in India post-deregulation was an enormous opportunity for early entrants to enter the telecom services business and compete for revenue with state-owned organizations.

At the same time, the growing demand for mobile services led to an expansion of industrial capacity, price wars, lowering of call tariffs, acquisitions, and declining industry profits.

India has one of the lowest call rates in the world. As the industry matured and consolidation took place, the old players had to alter their business models and strategies.

The external environment can be subdivided into 2 layers

• General Environment
• Task / Industry Environment

Accounting analysis, also referred as financial analysis or financial statement analysis, can be explained as an assessment of the stability, viability, and profitability of a business, sub-business, or project. A financial analysis is carried out by professionals who prepare reports through the use of info obtained from financial statements and other reports. Besides, one key area of financial analysis is the extrapolation of company’s past performance into an estimate of its future performance.

As explained by Investopedia, accounting analysis is one of the most common techniques for accounting analysis is calculating ratios from the data to compare with those of other companies or with the past performance of the company. For instance, return on assets is a common ratio which is used for determining the efficiency of a company at utilization of its assets as well as a measure of its profitability.

Methods of Accounting Analysis

The main methods adopted for accounting analysis include:

• Past performance

The accounting analysis uses past statistics across historical time periods for a single company, for example, the last 5 years.

• Future performance

The accounting analysis is performed by utilizing historical figures and certain statistical and mathematical techniques, counting present and future values. This extrapolation method acts as the main source of errors in accounting analysis for past statistics can play poor predictors for future prospects.

• Comparative performance

The accounting analysis is also done through comparison between similar business companies.

Objectives of accounting analysis

Carrying out accounting analysis is helpful in solving the following purposes:

• Solvency

Accounting analysis is helpful in assessing the ability of a company to repay its obligations to creditors and similar third parties in the long run.

• Profitability

Accounting analysis facilitates the ability of a company to earn income in addition to sustaining short term as well as long term growth. A company’s profitability level is based on the income statement, which provides reports on the company’s operation results.

• Liquidity

Accounting analysis aims at assessing a company’s ability to maintain positive cash flow in addition to satisfying immediate debts.

• Stability

Accounting analysis aims at assessing the company’s ability of sustaining itself in the long run, without the existence of significant losses in the business conduct. 

Overview of Financial Statement Analysis

Financial statement analysis involves gaining an understanding of an organization’s financial situation by reviewing its financial reports. The results can be used to make investment and lending decisions. This review involves identifying the following items for a company’s financial statements over a series of reporting periods:

• Trends. Create trend lines for key items in the financial statements over multiple time periods, to see how the company is performing. Typical trend lines are for revenue, the gross margin, net profits, cash, accounts receivable, and debt.
• Proportion analysis. An array of ratios are available for discerning the relationship between the sizes of various accounts in the financial statements. For example, one can calculate a company’s quick ratio to estimate its ability to pay its immediate liabilities, or its debt to equity ratio to see if it has taken on too much debt. These analyses are frequently between the revenues and expenses listed on the income statement and the assets, liabilities, and equity accounts listed on the balance sheet.

Financial statement analysis is an exceptionally powerful tool for a variety of users of financial statements, each having different objectives in learning about the financial circumstances of the entity.

Users of Financial Statement Analysis

There are a number of users of financial statement analysis. They are:

• Creditors. Anyone who has lent funds to a company is interested in its ability to pay back the debt, and so will focus on various cash flow measures.
• Investors. Both current and prospective investors examine financial statements to learn about a company’s ability to continue issuing dividends, or to generate cash flow, or to continue growing at its historical rate (depending upon their investment philosophies).
• Management. The company controller prepares an ongoing analysis of the company’s financial results, particularly in relation to a number of operational metrics that are not seen by outside entities (such as the cost per delivery, cost per distribution channel, profit by product, and so forth).
• Regulatory authorities. If a company is publicly held, its financial statements are examined by the Securities and Exchange Commission (if the company files in the United States) to see if its statements conform to the various accounting standards and the rules of the SEC.

Methods of Financial Statement Analysis

There are two key methods for analyzing financial statements. The first method is the use of horizontal and vertical analysis. Horizontal analysis is the comparison of financial information over a series of reporting periods, while vertical analysis is the proportional analysis of a financial statement, where each line item on a financial statement is listed as a percentage of another item. Typically, this means that every line item on an income statement is stated as a percentage of gross sales, while every line item on a balance sheet is stated as a percentage of total assets. Thus, horizontal analysis is the review of the results of multiple time periods, while vertical analysis is the review of the proportion of accounts to each other within a single period.

The second method for analyzing financial statements is the use of many kinds of ratios. Ratios are used to calculate the relative size of one number in relation to another. After a ratio is calculated, you can then compare it to the same ratio calculated for a prior period, or that is based on an industry average, to see if the company is performing in accordance with expectations. In a typical financial statement analysis, most ratios will be within expectations, while a small number will flag potential problems that will attract the attention of the reviewer. There are several general categories of ratios, each designed to examine a different aspect of a company’s performance. The general groups of ratios are:

1. Liquidity ratios. This is the most fundamentally important set of ratios, because they measure the ability of a company to remain in business. Click the following links for a thorough review of each ratio.
   • Cash coverage ratio. Shows the amount of cash available to pay interest.
   • Current ratio. Measures the amount of liquidity available to pay for current liabilities.
   • Quick ratio. The same as the current ratio, but does not include inventory.
   • Liquidity index. Measures the amount of time required to convert assets into cash.
2. Activity ratios. These ratios are a strong indicator of the quality of management, since they reveal how well management is utilizing company resources. Click the following links for a thorough review of each ratio.
   • Accounts payable turnover ratio. Measures the speed with which a company pays its suppliers.
   • Accounts receivable turnover ratio. Measures a company’s ability to collect accounts receivable.
   • Fixed asset turnover ratio. Measures a company’s ability to generate sales from a certain base of fixed assets.
   • Inventory turnover ratio. Measures the amount of inventory needed to support a given level of sales.
   • Sales to working capital ratio. Shows the amount of working capital required to support a given amount of sales.
   • Working capital turnover ratio. Measures a company’s ability to generate sales from a certain base of working capital.
3. Leverage ratios. These ratios reveal the extent to which a company is relying upon debt to fund its operations, and its ability to pay back the debt. Click the following links for a thorough review of each ratio.
   • Debt to equity ratio. Shows the extent to which management is willing to fund operations with debt, rather than equity.
   • Debt service coverage ratio. Reveals the ability of a company to pay its debt obligations.
   • Fixed charge coverage. Shows the ability of a company to pay for its fixed costs.
4. Profitability ratios. These ratios measure how well a company performs in generating a profit. Click the following links for a thorough review of each ratio.
   • Breakeven point. Reveals the sales level at which a company breaks even.
   • Contribution margin ratio. Shows the profits left after variable costs are subtracted from sales.
   • Gross profit ratio. Shows revenues minus the cost of goods sold, as a proportion of sales.
   • Margin of safety. Calculates the amount by which sales must drop before a company reaches its break even point.
   • Net profit ratio. Calculates the amount of profit after taxes and all expenses have been deducted from net sales.
   • Return on equity. Shows company profit as a percentage of equity.
   • Return on net assets. Shows company profits as a percentage of fixed assets and working capital.
   • Return on operating assets. Shows company profit as percentage of assets utilized.

Problems with Financial Statement Analysis

While financial statement analysis is an excellent tool, there are several issues to be aware of that can interfere with the interpretation of the analysis results. These issues are:

• Comparability between periods. The company preparing the financial statements may have changed the accounts in which it stores financial information, so that results may differ from period to period. For example, an expense may appear in the cost of goods sold in one period, and in administrative expenses in another period.
• Comparability between companies. An analyst frequently compares the financial ratios of different companies in order to see how they match up against each other. However, each company may aggregate financial information differently, so that the results of their ratios are not really comparable. This can lead an analyst to draw incorrect conclusions about the results of a company in comparison to its competitors.
• Operational information. Financial analysis only reviews a company’s financial information, not its operational information, so you cannot see a variety of key indicators of future performance, such as the size of the order backlog, or changes in warranty claims. Thus, financial analysis only presents part of the total picture.

The accounting for inventory involves determining the correct unit counts comprising ending inventory, and then assigning a value to those units. The resulting costs are then used to record an ending inventory value, as well as to calculate the cost of goods sold for the reporting period. These basic inventory accounting activities are expanded upon in the following bullet points:

• Determine ending unit counts. A company may use either a periodic or perpetual inventory system to maintain its inventory records. A periodic system relies upon a physical count to determine the ending inventory balance, while a perpetual system uses constant updates of the inventory records to arrive at the same goal.
• Improve record accuracy. If a company uses the perpetual inventory system to arrive at ending inventory balances, the accuracy of the transactions is paramount.
• Conduct physical counts. If a company uses the periodic inventory system to create ending inventory balances, the physical count must be conducted correctly. This involves the completion of a specific series of activities to improve the odds of counting all inventory items.
• Estimate ending inventory. There may be situations where it is not possible to conduct a physical count to arrive at the ending inventory balance. If so, the gross profit method or the retail inventory method can be used to derive an approximate ending balance.
• Assign costs to inventory. The main role of the accountant on a monthly basis is assigning costs to ending inventory unit counts. The basic concept of cost layering, which involves tracking tranches of inventory costs, involves the first in, first out (FIFO) layering system and the last in, first out (LIFO) system. A different approach is the assignment of a standard cost to each inventory item, rather than a historical cost.
• Allocate inventory to overhead. The typical production facility has a large amount of overhead costs, which must be allocated to the units produced in a reporting period.

The preceding bullet points cover the essential accounting for the valuation of inventory. In addition, it may be necessary to write down the inventory values for obsolete inventory, or for spoilage or scrap, or because the market value of some goods have declined below their cost. There may also be issues with assigning costs to joint and by-product inventory items. We expand upon these additional accounting activities in the following bullet points:

• Write down obsolete inventory. There must be a system in place for identifying obsolete inventory and writing down its associated cost.
• Review lower of cost or market. The accounting standards mandate that the carrying amount of inventory items be written down to their market values (subject to various limitations) if those market values decline below cost.
• Account for spoilage, rework, and scrap. In any manufacturing operation, there will inevitably be certain amounts of inventory spoilage, as well as items that must be scrapped or reworked. There is different accounting for normal and abnormal spoilage, the sale of spoiled goods, rework, scrap, and related topics.
• Account for joint products and by-products. Some production processes have split-off points at which multiple products are created. The accountant must decide upon a standard method for assigning product costs in these situations.
• There are a small number of disclosures about inventory that the accountant must include in the financial statements.

When goods or services are sold to a customer, and the customer is allowed to pay at a later date, this is known as selling on credit, and creates a liability for the customer to pay the seller. Conversely, this creates an asset for the seller, which is called accounts receivable. This is considered a short-term asset, since the seller is normally paid in less than one year.

An account receivable is documented through an invoice, which the seller is responsible for issuing to the customer through a billing procedure. The invoice describes the goods or services that have been sold to the customer, the amount it owes the seller (including sales taxes and freight charges), and when it is supposed to pay.

If the seller is operating under the cash basis of accounting, it only record transactions in its accounting records (which are then compiled into the financial statements) when cash is either paid or received. Since issuing an invoice does not involve any change in cash, there is no record of accounts receivable in the accounting records. Only when the customer pays does the seller record a sale.

If the seller is operating under the more widely-used accrual basis of accounting, it records transactions irrespective of any changes in cash. This is the system under which an account receivable is recorded. In addition, there is a risk that the customer will not pay. If so, the seller can either charge these losses to expense when they occur (known as the direct write-off method) or it can anticipate the amount of such losses and charge an estimated amount to expense (known as the allowance method). The latter method is preferred, because the seller is matching revenues with bad debt expenses in the same period (known as the matching principle).

We will illustrate these concepts below.

Recording Sales of Services on Credit

When services are sold to a customer, the seller normally creates an invoice in its accounting software, which automatically creates an entry to credit the sales account and debit the accounts receivable account. When the customer later pays the invoice, the seller would debit the cash account and credit the accounts receivable account. For example, ABC International billings a customer for $10,000 in services, and records the following entry:

	Debit	Credit
Accounts receivable	10,000
Sales		10,000

This journal entry increases the accounts receivable asset for ABC, which appears as a short-term asset in its balance sheet. In addition, it increases sales, which appear in ABC’s income statement.

Recording Sales of Goods on Credit

If the seller were to sell goods to a customer on credit, then not only would it have to record the sale and related account receivable (as was the case for the sale of services), but it would also record the reduction in inventory that was sold to the customer, which then appears in the cost of goods sold expense. This later transaction reduces the inventory asset in the balance sheet and increases the expenses in the income statement. For example, if ABC International were to conclude a sale transaction for $25,000 in which it sold $12,000 of merchandise to the customer, its journal entry would be:

	Debit	Credit
Accounts receivable	25,000
Sales		25,000
Cost of goods sold	12,000
Inventory		12,000

There is an issue with the timing of the preceding sale transaction. If the sale is made under FOB shipping point terms, the seller is supposed to record both the sale transaction and related charge to cost of goods sold at the time when the shipment leaves its shipping dock. From that point onward, the delivery is technically the responsibility of either a third-party shipper or the buyer.

If the sale is made under FOB destination terms, then the seller is supposed to record these transactions when the shipment arrives at the customer; this is because the delivery is still the responsibility of the seller until it reaches the customer’s location.

From a practical perspective, many companies record their sale transactions as though the delivery terms were FOB shipping point, because it is easy to verify. Recording the transaction upon arrival at the customer requires substantially more work to verify.

Accounting for Bad Debt

If a company sells on credit, customers will occasionally be unable to pay, in which case the seller should charge the account receivable to expense as a bad debt. The best way to do so is to estimate the amount of bad debt that will eventually arise, and accrue an expense for it at the end of each reporting period. The debit is to the bad debt expense account, which causes an expense to appear in the income statement. The credit is to the allowance for bad debts account, which is a reserve account that appears in the balance sheet. Later, when a specific invoice is clearly identifiable as a bad debt, the accountant can eliminate the account receivable with a credit, and reduce the reserve with a debit. 

For example, ABC International invoices $1 million of invoices to various customers in January and estimates that $40,000 of this amount will not be paid. Accordingly, it records the following entry to create a bad debt reserve:

	Debit	Credit
Bad debt expense	40,000
Allowance for doubtful accounts		40,000

In March, ABC clearly identifies $18,000 of invoices that will not be paid. It uses the following entry to eliminate the invoices and draw down the reserve balance:

	Debit	Credit
Allowance for doubtful accounts	18,000
Accounts receivable		18,000

If the customer were to later pay the invoice, ABC would simply reverse the entry, so that the allowance account is increased back to its former level.

An alternative method is the direct write-off method, where the seller only recognizes a bad debt expense when it can identify a specific invoice that will not be paid. Under this approach, the accountant debits the bad debt expense and credits accounts receivable (thereby avoiding the use of an allowance account). It is not the preferred method for recording bad debts, because it introduces a delay between the recognition of a sale and the recognition of any related bad debt expense (which violates the matching principle).

Accounting for Early Payment Discounts

If a company offers customers a discount if they pay early and they take advantage of the offer, then they will pay an amount less than the invoice total. The accountant needs to eliminate this residual balance by charging it to the sales discounts account, which will appear in the income statement as a profit reduction.

For example, ABC International offers a $100 discount to a customer if it pays a $2,000 invoice within 10 days of the invoice date. The customer does so. ABC uses the following entry to record the transaction:

	Debit	Credit
Cash	1,900
Sales discounts	100
Accounts receivable		2,000

The Accounts Receivable Aging

All outstanding accounts receivable are compiled into the accounts receivable aging report, which is typically structured to show invoices that are current, overdue by 0 to 30 days, by 31 to 60 days, 61 to 90 days, or 90+ days. This report is used to derive the allowance for bad debts, and is also a key tool of the collections department, which uses it to determine which invoices are sufficiently overdue to require follow-up action.

Accounts Receivable Reconciliation

The accounts receivable aging report itemizes all receivables in the accounting system, so its total should match the ending balance in the accounts receivable general ledger account. The accounting staff should reconcile the two as part of the period-end closing process. If there is a difference between the report total and the general ledger balance, the difference is likely to be a journal entry that was made against the general ledger account, instead of being recorded as a formal credit memo or debit memo that would appear in the aging report.

A company, being an artificial person, cannot generate its own capital which has necessarily to be collected from several persons. These persons are known as shareholders and the amount contributed by them is called share capital.

Since the number of shareholders is very large, a separate capital account cannot be opened for each one of them. Hence, innumerable streams of capital contribution merge their identities in a common capital account called as ‘Share Capital Account’.

Categories of Share Capital

From accounting point of view the share capital of the company can be classified as follows:

Authorised Capital: Authorised capital is the amount of share capital which a company is authorised to issue by its Memorandum of Association. The company cannot raise more than the amount of capital as specified in the Memorandum of Association. It is also called Nominal or Registered capital. The authorised capital can be increased or decreased as per the procedure laid down in the Companies Act. It should be noted that the company need not issue the entire authorised capital for public subscription at a time. Depending upon its requirement, it may issue share capital but in any case, it should not be more than the amount of authorised capital.

• Issued Capital: It is that part of the authorised capital which is actually issued to the public for subscription including the shares allotted to vendors and the signatories to the company’s memorandum. The authorised capital which is not offered for public subscription is known as ‘unissued capital’. Unissued capital may be offered for public subscription at a later date.
• Subscribed Capital: It is that part of the issued capital which has been actually subscribed by the public. When the shares offered for public subscription are subscribed fully by the public the issued capital and subscribed capital would be the same. It may be noted that ultimately, the subscribed capital and issued capital are the same because if the number of share, subscribed is less than what is offered, the company allot only the number of shares for which subscription has been received. In case it is higher than what is offered, the allotment will be equal to the offer. In other words, the fact of over subscription is not reflected in the books.
• Called up Capital: It is that part of the subscribed capital which has been called up on the shares. The company may decide to call the entire amount or part of the face value of the shares. For example, if the face value (also called nominal value) of a share allotted is Rs. 10 and the company has called up only Rs. 7 per share, in that scenario, the called up capital is Rs. 7 per share. The remaining Rs. 3 may be collected from its shareholders as and when needed.
• Paid up Capital: It is that portion of the called up capital which has been actually received from the shareholders. When the shareholders have paid all the call amount, the called up capital is the same to the paid up capital. If any of the shareholders has not paid amount on calls, such an amount may be called as ‘calls in arrears’. Therefore, paid up capital is equal to the called-up capital minus call in arrears.
• Uncalled Capital: That portion of the subscribed capital which has not yet been called up. As stated earlier, the company may collect this amount any time when it needs further funds.

Accounting for Share Capital

• Reserve Capital: A company may reserve a portion of its uncalled capital to be called only in the event of winding up of the company. Such uncalled amount is called ‘Reserve Capital’ of the company. It is available only for the creditors on winding up of the company.

Let us take the following example and show how the share capital will be shown in the balance sheet. Sunrise Company Ltd., New Delhi, has registered its capital as Rs. 40,00,000, divided into 4,00,000 shares of Rs. 10 each. The company offered to the public for subscription of 2,00,000 shares of Rs. 10 each, as Rs. 2 on application, Rs.3 on allotment, Rs.3 on first call and the balance on final call. The company received applications for 2,50,000 shares. The company finalised the allotment on 2,00,000 shares and rejected applications for 50,000 shares. The company did not make the final call. The company received all the amount except on 2,000 shares where call money has not been received.

The above amounts will be shown in the Notes to Accounts of the balance sheet of Sunrise Company Ltd. as follows:

Notes to accounts
Share Capital		(Rs.)
Authorised or Registered or Nominal Capital: 4,00,000 Shares of Rs. 10 each		40,00,000
Issued Capital 2,00,000 Shares of Rs. 10 each		20,00,000
Subscribed Capital Subscribed but not fully paid up 2,00,000 Shares of Rs. 10 each, Rs. 8 called up Less: Calls in Arrears	16,00,000 6,000	15,94,000

A liability is a legally binding obligation payable to another entity. Liabilities are a component of the accounting equation, where liabilities plus equity equals the assets appearing on an organization’s balance sheet.

Examples of liabilities are:

• Accounts payable
• Accrued liabilities
• Accrued wages
• Deferred revenue
• Interest payable
• Sales taxes payable

Accounting for Liabilities

For all of these sample liabilities, a company records a credit balance in a liability account. There may be rare cases where there is a negative liability (essentially an asset or a decline in a liability), in which case there may be a debit balance in a liability account. The basic accounting for liabilities is to credit a liability account. The offsetting debit can be to a variety of accounts. For example:

• Accounts payable. The offsetting debit may be to an expense account, if the item being purchased is consumed within the current accounting period. Alternatively, the offsetting debit may be to an asset account, if the item is to be used over several periods (as is the case with a fixed asset).
• Accrued liabilities. The offsetting debit is nearly always to an expense account, since accrued liabilities are usually only recognized as part of the closing process, where there is an expense but no documentation in the form of a supplier invoice.
• Accrued wages. The offsetting debit is to the wage expense account, and reflects earned but unpaid hours at the end of the reporting period.
• Deferred revenue. The offsetting debit is usually either the cash account or the accounts receivable account, and reflects a situation where a customer has at least been billed for services rendered or goods shipped, but the revenue creation process is not yet complete. A variation on this concept is a customer prepayments account, or a customer deposits account.
• Interest payable. The offsetting debit is to the interest expense account, and indicates the amount of interest expense accrued by a business, but not yet billed to it by a lender.
• Sales taxes payable. The offsetting debit is the accounts receivable account, which is where the sales tax billing to the customer is located.

In short, there is a diversity of treatment for the debit side of liability accounting.

Liability Classifications

When presenting liabilities on the balance sheet, they must be classified as either current liabilities or long-term liabilities. A liability is classified as a current liability if it is expected to be settled within one year. All other liabilities are classified as long-term. Accounts payable, accrued liabilities, and taxes payable are usually classified as current liabilities. If a portion of a long-term debt is payable within the next year, that portion is classified as a current liability. Most liabilities are classified as current liabilities.

Contingent Liabilities

There are also cases where there is a possibility that a business may have a liability. This is known as a contingent liability. You should record a contingent liability if it is probable that a loss will occur, and you can reasonably estimate the amount of the loss. If a contingent liability is only possible, or if the amount cannot be estimated, then it is (at most) only noted in the disclosures that accompany the financial statements. Examples of contingent liabilities are the outcome of a lawsuit, a government investigation, or the threat of expropriation. A warranty can also be considered a contingent liability.

Other Liability Issues

When you record a liability in the accounting records, this does not mean that you are also setting aside funds to pay for the liability when it must eventually be paid recording a liability has no immediate impact on cash flow.