Financial Management of Public Sector Unit (PSU) - Notes

7/28/2019 Financial Management of Public Sector Unit (PSU) - Notes

1/23

Financial Management of PSUs:

1. What is the nature and scope of finance function in government

companies? What are the special features of financial function in

government companies? mine

Ans : Globalization of Indian economy has made it necessary for Public

Sector Undertakings (PSUs) to be sound in terms of profitability and

earnings per share. For PSUs to be selfsustaining organizations, Financial

Management assumes a lot of significance.

The nature of the finance function is shaped mainly by the structure of the

organization. The nature of finance function of would be more complex for

a multi-product, multi-unit and multi-functional undertaking than that for a

PSU having a simple structure in terms of products and location.

Over the years the organization for finance has been undergoing a shift from

a pure functional and centralized type to decentralized and divisionalized

type of organization.

The finance function in PSUs is becoming more and more inclusive. It has

grown beyond traditional boundaries to newer avenues such as restructuring

and corporate governance.

The scope of the finance function has undergone a great transformation, the

area of focus of the finance function has widened to include other functions

having a bearing upon the management of investments and financing.

The scope of the financial function in PSUs includes:

Projecting cash-flows by providing for risk.

Determining financial resources required to meet the companies

operating program.

Forecasting the amount of requirement


2/23

Developing best plan to obtain external funds.

2. How are investment, financing and dividend decisions organized in

government companies?

Ans:

Investment management :

Investment proposals are examined by various agencies of the government

including a Project Appraisal Division of the Planning Commission, the

Department of Public Enterprises, the Public Investment Board, and the

Cabinet Committee of Economic Affairs.

The limits on capital expenditure and approvals required are :

Upto Rs. 5 crore By the enterprise

Upto Rs. 5-20 crore By the enterprise with integrated financial system

Upto Rs. 20-50 crore To be approved by the administrative ministry

Proposals above Rs. 50 crore By the Project appraisal division, public

investment board and the Cabinet Committee on

external affairs

Financing Decisions:

The Government has been the main provider of equity and long term debt in

PSUs. Internal financing plays an insignificant role as a source of financing.

The financial institutions have provided about 2% of the total long term

investment needs. Foreign equity/loans account for more than 10% of the


3/23

long term investment needs. Differed credits take a lions share of foreign

finance.

Private participation from Indian business and investors is about 11% of the

total long term resources. Many PSUs have raised short term finance

through commercial papers in the post 1990 period.

Dividend payments in PSUs:

In 1988-89, the dividends declared were less than 1% of the paid up capital.

Due to a revised stipulation announced as a part of the New Economic

Policy, these enterprises have to now declare 50% of their profits as

dividends. However in 97-98, the dividends declared were a mere 30% of

the net profit earned by these enterprises.

The percentage increased in the years to follow and 70 % profits are nowdeclared as dividends. It is very heartening to see that over the years the

number of dividend declaring PSUs has increased along with the quantum

of dividends declared.

3. What is the nature of working capital in government companies? What

steps should be taken to improve the effectiveness of working capital

management in government companies?

Ans: The management of working Capital is a vital element in PSUs.

The working capital requirements of PSUs are generally met through

cash credits and advances arranged with the State Bank of India and

other nationalized banks. The amount of outstanding cash

credits/advances drawn by the Central public enterprises (CPSUs) from

Banks and others as on March 31st 2003 was Rs.69,294 crore.

In special cases non-plan loans are also advanced by the central

Government to some enterprises for meeting their working Capital


4/23

requirements. As on March 31st 2003, a total of Rs. 1,815 crore was

outstanding from 51 enterprises as working capital loan from the Central

Government.

Steps that should be taken to improve effectiveness of working Capital

management:

o Current liabilities should be given greater attention as a

component of source of funds.

o Spread of awareness concerning the current techniques to working

capital management.

o Avoid excess buildup of working capital by favourable credit

management.

4. What is performance budgeting? What is Programme Budgeting? What

are their pros and cons?

Ans:

Performance Budgeting (PB):


5/23

It is a system wherein managers are provided with a flexibility to utilize

department or organizations resources as required in return for their

commitment to achieve certain performance results. PB is a system of

planning, budgeting and evaluation that emphasizes the relationship

between money budgeted and results expected.

Common characteristics of a Performance budget include:

o Organizations identification of mission goals and objectives.

o Linkage of strategic planning information with the budget.

o Development and integration of performance measures into the

budget.

o Desegregation of expenditures into various broad areas (such aspersonnel, operating expenses and Capital outlays) rather than

more specific line-items.

Advantages of PB are as follows:

PB has more of a policy-making orientation. It connects plans, measures

and budgets.

PB forces departments and policy makers to think about the big picture. PB provides better information about the impact of budget decisions on

people.

It gives the department increased budgetary flexibility and incentives for

generating budget savings.

Disadvantages:

Emphasis on quantity, not quality of the activity being monitored.


6/23

The link between performance measures and resource allocations are

subject to political choices.

Lack of Credible and useful performance information.

Difficulties arising in achieving Consensus on goals and measures.

Programme Budgeting:

Under a program budgeting system, department or agency budget

requests not only include the funding that it would like to receive, but

also the outputs and outcomes they expect to produce as a result of that

funding. The legislature then establishes performance targets fo

outcomes and outputs in the implementing act to the appropriations act.

Department or agencies then report their actual performance in their long

range programme plans and budget requests for the following fiscal year.

Agencies may give incentives for performance that exceeds standards or

disincentives for performance that falls below standards. These

incentives and disincentives can be monetary or non-monetary.

An example of a monetary incentive would be performance bonuses for

employees and managers. An example of a non-monetary incentivewould be an increase in budget flexibility.

Thus by its nature a programme budget focuses on the output services

that the programme provides to its users. It also more readily relates to

overall organizational goals and objectives


7/23

5. What is Zero-Base budgeting? How is it different from traditional

budgeting? What are its merits and demerits?

ANSWER:-

ZBB is a budgeting method for a corporation or government in which all

expenditures must be justified afresh each year & not just in excess of the

previous year. Under ZBB, nothing is considered as sacrosanct. Every time, the

managers are supposed to start from scratch or writing on a clean slate.

ZBB is claimed to be a new technique of planning & decision making. It

reverses the working process of traditional budgeting. In traditional budgeting,

departmental managers need to justify only increase over the previous year

budget. This means what has been already spent is automatically sanctioned.

While in ZBB, no reference is made to the previous level of expenditure. Every

department function is reviewed comprehensively & all expenditures rather

than only increases, are approved. The Zero-base is indifferent to whether the

total budget is increasing or decreasing.

Merits:-

Elimination of obsolete, non-relevant decision packages.

Increased or decreased levels of funding for some decision packages &addition of new decision packages.

ZBB encourages budget participation at the operating level. As a result,

managers & employees become more focused.

The comprehensive resources cost analysis process is a strong internal

planning characteristic of ZBB

ZBB, when properly implemented holds great promise for assisting

personnel of an organization to plan & make decisions about the most

efficient & effective ways to use their available resources to achievetheir defines mission, goals & objectives.

Results in efficient allocation of resources as it is based on needs and

benefits.

Forces and derives managers to think critically in order to find out cost

effective ways to improve operations.


8/23

Useful for service department where the output is difficult to identify.

Increases communication and coordination within the organization.

Managers and employees learn more about the organizations activities

and problems.Demerits:-

Increase in paper work and time consuming.

In certain areas of the organization, it is difficult to define decision units

and decision packages.

It forces the managers to justify every related to expenditure. Sometimes,

certain departments like R&D may be threatened while production

department would benefit.

In the first year, cost of training, paper work and implementation of ZBB

may go up because without its proper understanding, it cannot be

successfully implemented.

Organization may face some resistance from the employees and their

unions.

Difficult to administer and communicate the budgeting because more

managers are involved in the process. Since ZBB threatens certain

positions of the managers and executives, they may play games andpolitics.

6. Explain the steps in the process of zero-base budgeting?

ANSWER:-

The development & implementation of the ZBB model requires managers &

others in the organization to engage in several major planning, analytic &

decision-making processes. These major processes of ZBB include the

following:-

Identification or redefining the mission and goals of the organization.


9/23

Identification of the organizations Decision Units and Decision

Packages.

Ranking of decision packages based on cost-benefit or qualitative

criteria.

Fixing a cut-off point for funding.

Acceptance and allocation of resources.

Budget execution.

Monitoring and Evaluation.

7. What is a Memorandum of Understanding (MoU)? How is it structured?

How does it help in performance improvement and measurement?

ANSWER:-

MoU is supposed to be a freely negotiated document between the government,

acting as a owner, & a specific PSU. It is also supposed to clearly specify the

intentions, obligations & mutual responsibilities of both parties to the MoU. If

either of the two conditions is violated, the effectiveness of the MoU as an

instrument of performance improvement is bound to be affected.

The basic philosophy guiding the MoU is to create an understanding between

the government & the PUSs about the accountability of the latter to the former& the autonomy the former would provide to the latter in the task of achieving

the objectives for which the PSUs were set up. It was expected that such an

agreement would minimize the reference that the PSUs were expected to make

to the government, on the one hand, & the control that the government would

exercise on the PSUs to ensure their effective performance, on the other.

The MoU makes an attempt to move the management of PSUs from

management by controls & procedures to the management by results &

objectives.

Objectives of MoU system:

1. Measure the performance of the PSUs taking into account the

complexities effusing social & financial objectives & translating them

into measurable parameters.

2. Ensure simultaneous increase in autonomy as well as accountability.


10/23

3. Set up new institution & administrative & personnel.

4. Replace multiply principles with multiple objectives with clarity in

goals & objectives.

Structure of MoU

The MoU is not merely a document, it is the way of life or a management

system. This is tool for performance improvement incorporates within its fold

three sub-system, namely, performance information system, performance

evaluation system, & performance incentive system.

Performance evaluation in MoU involves five steps. First three steps are taken

at the beginning of he year & the last two steps are taken at the end of the year.

Beginning of the year

Step 1: CRITERIA SELECTION: - In this first step, one has to choose

appropriate set of criteria to be included in the MoU. The criteria included in

the MoU should mearsure only those aspects of the managerial performance

which are under managers control.

Performance criteria must be selected carefully & not arbitrarily. These should

be based on the enterprises corporate plan that looks at three to five years in

the future. They must also be consistent with plan & budgetary goals of the

government.

MoU is an instrument that measures the performance of the manager & not thatof the enterprises. While selecting performance criteria this must be kept in

mind and only those parameters that judge managerial performance should be

selected.

Step 2:- CRITERIA WEIGHT SELECTION:- For running an enterprise

successfully a Chief Executive has to undertake a number of tasks. However,

not all the tasks are of equal importance. A smart Chief Executive therefore,

priorities his tasks based on his perception of relative importance of different

activities in hand.

In the interest of clarity of purpose it is necessary that from long list of things to

do, the manager must be told what are the relative priorities so that he can

allocate his time more effectively in achieving those priorities.

Step 3:- CRITERIA VALUE SELECTION:-To understand on needs to

distinguish between criteria & criteria value. Now, kilometers per liter in a

criterion to measure efficiency of motor vehicles, however, 10 kilometer/liter


11/23

may be excellent for a truck bit it is very bad for a scooter. This value of 10

kilometer/liter is a criteria value. It is a value, which distinguish various levels

of performance. The MoU is rated on a 5-point scale, where 1 represents

excellent performance & 5 represents poor performance.

This indeed is very heart of the MoU philosophy. Once you have specified theobjectives for the managers you should not interfere in the operation & wait till

the end of the year for them to deliver the goods.

The selection of criterion value should be carried out through a participative

process. Experience suggests that without a participative approach, targets tend

to take the form of formal directives which are often overtly accepted &

covertly resisted. These targets should be easy to understand & well defined.

The sources of information which could assist in setting criterion values

include:

The original objectives at the project formulation stage.

Comparisons with similar undertakings of other selected developed &

developing countries.

Comparisons with the performance of the same firm in the previous

years.

Professional judgment by third parties.

Professional judgment at the ministry level.

Professional judgment at the enterprise level.

At the end of the year

Step 4:- PERFORMANCE VALUATION:- The forth step is taken in the end of

the year, when we look at the achievement of PSUs & compare them with the

criteria values & determine the scores. This is the final step in the performance

evaluation exercise cannot be mechanical procedure. The value of the

composite scores will also lie between 1 & 5. If management has done

excellent in all fonts including in the MoU, they will get a score of 1.

It measures the ability of the enterprise to its own commitments.

Step 5:- PERFORMANCE REWARD:- While performance evaluation of PSUs

provide a measures of the degree of achievement of the objectives set out,

evaluation by itself does not lead to improvement of performance. Unless

performance evaluation is coupled with a system of rewards & penalties &


12/23

utilized as a means for that purpose, it provides no motivation to the PSUs for

improving their performance. A transparent system of rewards & punishment is

thus a corollary to the introduction of an objective performance evaluation

system of the PSUs. Thus a performance rewards scheme constitutes an

essential complement of MoU system.


13/23

Financial Management of Sick Units :

1. What are the causes of industrial sickness?

Definition of sickness:-

The Companies Act ,2002 defines a sick company as one,

i. which has accumulated losses in any financial year equal to 50% or more

of its average net worth during four years immediately preceding the

financial year in question or

ii. which has failed to repay its debts within any three consecutive quarters

on demand for repayment by its creditors.

Causes of sickness:-

The sickness in any industry can be caused by various reasons which

can be categorized or because of

i. unfavourable external environment

ii. Managerial deficiency

Unfavourable external environment-

The firm may cause the sickness because of unfavourable

external environment. External environment is the environment

which affected the functioning of the firm and the control of these

factors is not in hand of any industry.


14/23

Following are some factors which cause the sickness.

a. Shortage of inputs like power or basic raw material

b. Change in government policies

c. Development of new technologyd. Sudden decline in orders from the government

e. Change in customer preferences

f. Natural calamities

g. Adverse international development

Managerial deficiency

These deficiencies can be classified as per the function like

Production , finance , marketing, human resource.

Under these function there are some other reason because of

which the industry face the problem of sickness

Production;-

a. Improper location

b. wrong technology

c. uneconomic plant size

d. unsuitable plant & machinery

e. poor quality control

d. poor R&D

f. poor maintenance

Finance: Finance is the lifeblood of business. It links and passes through all areas of a

business unit. The problem areas may be because of,

1.


15/23

The promoters might have chosen a project which is beyond their

financial capacity. This often happens due to over ambitious approach of

entrepreneurs. A bigger project needs a bigger investment and

accordingly a higher promoters contribution in absolute terms. If the

promoters are not able to mobilize their contribution, with the sole idea

of implementing the project, they often resort to borrowings, invariably

at higher interest rates with the hope of clearing the high cost borrowings

once the project takes off

2. Funding a project with a higher debt component than that it can safety

bear is another reason for sickness, since such projects will not be able to

service the high interest charges.

3. Using short term funds for acquiring fixed assets is an area of concern.

This will put the liquidity position of the business in strain when the

short term obligations become due for repayment.

4. Improper inventory management policy will lead to holding huge stock

of finished products, late realization of debts from sundry debtors, lack

of proper planning to pay to creditors of raw materials, etc., which willall have telling effects on the operation of a business unit.

Marketing;

a. Inaccurate demand projection

b. Improper product-mix

c. Wrong product positioning

d. Irrational price structure

e. Inadequate sales promotion

f. High distribution cost

g. Poor customer service


16/23

Human resource

a. Ineffective leadership

b. Inadequate human resource

c. Poor organization design

d. Insufficient training

e. Irrational compensation

2. List the symptoms which might indicate that sickness lies ahead.

As the sickness in any industry does not occur overnight, but develops

gradually over time. Any sick industry shows some common symptoms.

Those are :

a. Delay in payment to supplier:

When the company faces the problem of sickness the company fail to

pay to its suppliers on time. As a result they always ask for the

extension to pay the amount.

b. Irregularity in the bank account;

The sick unit may fail to keep the regularity in the bank account

which can be the sign of sickness.

c. Delay in payment to bank or financial institutions

As the sick unit ask for the time to supplier for the payment the same

way it can ask for bank or financial institutions for increase the limit

of credit.


17/23

d. Frequent request to banks for additional credit

In addition to delay in the payment to supplier and bank the sick unit

might ask for the additional credit to meet its obligations.

e. Inability to take trade risk

f. Extension of accounting period

g. Low turnover of assets

h. Decline in prices of shares;

The prices of the sick unit or industry face the problem of reducing

the share prices over a period of time

i. Excessive turnover of personnel

j. Accumulation of inventories

3. Discuss the univariate analysis for predicting industrial sickness.

Univariate analysis aims to predict sickness on the basis of a singlefinancial ratio. Though many financial ratios were used by analysts for

predicting sickness, there was no consensus as to what the most

appropriate ratio is for the prediction of sickness. Such a situation

prevailed till William H.Beaver published

his study on univariate analysis in the year 1966. Beaver examined the

predicative

power of 30 different financial ratios by choosing a sample of 79 firms that had

become sick and 79 firms that were healthy for the same period of time. The

sample was so chosen that for each failed (sick) firm, a healthy firm operating

in the same industry and having comparative size was included in the sample

set. For both the set of samples of 79 firms each, Beaver examined the

behaviour of 30 different financial ratios during the period of 5 years prior to


18/23

the failure. The main finding of Beaver was that the ratio that is most useful in

predicting impending sickness is the ratio of cash flow to total debt, since this

ratio showed the minimum error in his prediction.

4. Discuss briefly how multivariate analysis may be employed for

predicting industrial sickness.

Univariate analysis examines the predictive power of individual financial

ratios. The joint effect of more than one financial ratio in predicting sickness is

not studied in univariate analysis. Multivariate analysis, on the other hand, aims

to predict industrial sickness by studying the combined influence of several

financial ratios.

Altman. E.I.presented his model of multivariate analysis for predicting

industrial sickness in the year 1966. In his model, Altman combined several

financial ratios into a single index. He named this index as Z-score. His

analysis was based on a statistical procedure known as multiple discriminate

analysis (MDA). Altman studied a sample of 33 bankrupt firms along with a

paired sample of 33 non-bankrupt firms. He examined 22 financial ratios to

identify their combined influence on sickness and selected five ratios, which in

his opinion jointly possess the maximum power to predict bankruptcy.

Altman derived a discriminant function (Z) that contains five financial ratios.

The discriminant function derived by Altman is as under:

Z = 1.20x1 + 1.40x2 + 3.30x3 + 0.60x4 + 0.999x5

Where,

Z = discriminant score

x1 = (working capital) (total assets)

x2 = (retained earnings) (total assets)

x3 = (earnings before interest and tax) (total assets)


19/23

x4 = (market value of equity) (book value of total debt)

x5 = (sales) (total assets)

A cut-off point for the Z score was determined by Altman in such a way that

it minimized the

overlap between bankrupt and non-bankrupt groups. Altman found that a cut

off value of 2.675 for

Z minimized the possibility of misclassification. Thus, as per Altmans

analysis, firms with Z

score less than 2.675 are prone to become bankrupt and firms with Z score

more than 2.675 are

free from the threat of bankruptcy.

4. What aspects should be covered in viability study?

Ans :

Revival of a sick unit

When an industrial unit is identified as sick, a viability study should be

conducted to assess whether the unit can be revived within a reasonable period.

If the viability study suggests that the unit can be rehabilitated, a suitable plan

must be undertaken, if the study indicates that the unit is better dead than alive

steps are taken to liquidate it.

Viability study

It generally covers the following:-

Market Analysis

Market share behavior over the past few years

Growth rate of total market

Emergence of competition

Production/Technical Analysis


20/23

Technological capability of the firm

Plant condition

Supply of raw material

Finance

Liquidity position

Leverage analysis

Personnel organization

Human Resource

Leadership

Environment

Supply of raw material

Availability of power, fuel and water

The viability study may suggest one of the following:

a. The unit can be revived by adopting one or more of the following

measures; debt restructuring, infusion of funds, correction of functional

deficiencies, replacement of existing management because of its

incompetence.

b. The unit is not potentially viable- this essentially implies that thebenefits expected from remedial measures are less than the cost of such

remedial measures.

5. What are the unusual components of the revival programme?

Ans :

Revival Programme

Usually involves:-

Settlement with creditors


21/23

A sick unit is not able to honour its commitments to its creditors. To alleviate

its financial distress, a settlement scheme has to be worked out which may

involve one or more of the following: rescheduling of principal and interest

payment; waiver of interest; conversion of debt to equity; payment of arrears in

installments.

Provision of Additional Capital

Typically a revival programme entails provision of additional capital. This may

be required for modernization and repair of plant and machinery, for purchase

of balancing equipments, for sustaining a new marketing drive, and for

enhanced working capital needed to support a higher level of operations. The

additional capital has to be provided on concessional terms, at least for the

initial years, so that the financial burden on the unit is not high.

Divestment and Disposal

The revival programme may involve divestment of unprofitable plants and

operations and disposal of slow moving and obsolete stocks. The thrust of these

actions should be to strengthen the liquidity of the unit and facilitate

reallocation of resources for enhancing the profitability of the unit.

Reformulation of product market strategy

Many a business failures can be traced to an ill-conceived product market

strategy. For reviving a sick unit, its product market strategy may have to be

significantly reformulated to improve the prospects of its profitable recovery.

Modernization of plant and machinery

In order to improve manufacturing efficiency, plant and machinery may have to

be modernized, renovated and repaired. This may be essential for attaining

certain cost standards and quality norms for competing effectively in the

market place.

Reduction in manpower

Generally, sick firms tend to be over-staffed. The revival programme must seek

to reduce superfluous manpower. Remember an old managerial saw: The

leaner the organization, the greater are its chances of survival.


22/23

Strict control over costs

A profitable organization can afford wastefulness and laxity in its expenditures.

A zero base review of all the discretionary expenses may be undertaken to

eliminate programmes and activities which are a drain on the finances of the

firm.

Streamlining of operations

Manufacturing, purchasing and selling operations have to be meticulously

examined so that they can be streamlined. Value engineering, standardization,

cost benefit analysis, and other approaches should be exploited fully to improve

the efficiency of the operations.

workers participation

workers participation in management enhances employee commitment,

motivation, and morale. Further, the suggestions offered by the workers result

in improvements that lead to higher manufacturing efficiency and productivity.

A sick unit which is being revived, can perhaps benefit even more from

workers participation in management.

Change of management

A change in management may be necessary where the present management is

dishonest. It has been observed that a new chief executive, who is competentand committed can often bring about dramatic results.

6. Discuss the common ingredients of corporate turnaround.

Ans :

A turnaround situation represents an unusual phase in the life history of a

firm and requires a very different approach to management as comparedto a normal situation.

The key elements found commonly found in turnarounds are:

A change in the top management.

A substantial involvement of top management in day to day operations.


23/23

An emphasis on projects that have a quick payoff.

Opportunistic action, improvisation, crisis management, and short term

expediency.

Turnaround Story

TVS Suzuki

It started operations in 1987-88 on an optimistic note. However its performance

deteriorated in the following three years. While it still made profits in 1988-89,

it incurred losses in 1990-90. By early 1991 the situation was pretty bad

because of intense competition in the marketplace.

With the determination to fight competition and improve performance, the

company took a series of steps.

A six month, week by week, cost reduction drive focused on raw

material cost, manpower cost and non value added expenditures, this led

to a drop of 30% in operating costs.

A massive exercise in value engineering undertaken in tandem with

Suzuki, this resulted in a saving of Rs 10 million pm.

A product improvement strategy to introduce a new model every few

years, to build market share.

A renewed marketing drive backed by a higher advertising outlay and a

new marketing and vendor policy.

Financial Management of Public Sector Unit (PSU) - Notes

Documents

Transcript of Financial Management of Public Sector Unit (PSU) - Notes