Chapter - 36

Financial Management in Government Companies

Chapter Objectives
 Understand the nature and the scope of

finance function in government (or public sector) companies.  Discuss the features of investment, financing, working capital and dividend decisions in government companies.  Review the concept, structure and significance of memorandum of understanding (MoU).  Explain the meaning and application of zerobase budgeting and performance budgeting to government companies.
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Finance Function in PSUs
 Projecting cash-flows by providing for risks.  Determining the financial resources required to

meet the company's operating programme.  Forecasting how much of the requirements would be met by internal generation of funds and how much would have to be obtained from outside.  Developing the best plans to obtain external funds.  Establishing and maintaining a system of financial control governing the allocation and use of funds.
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Finance Function in PSUs
 Formulating programmes to provide the most

effective profit-volume cost relationship.  Analysing the financial results of all operations, reporting the facts to the top management, and making recommendations concerning future operations.  Carrying out special studies with a view to reduce costs, and improve efficiency and profitability.  Carrying out feasibility studies and preparing project reports.  Budgeting.
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Finance Department
Preparation of long-term operating budget. Preparation of long-term capital expenditure. Preparation of the annual operating budget. Preparing the budget returns that flow out of the comprehensive budgetary system in operation.  Analysing variations between budget figures and the expenditure incurred.  Explaining the causes of variation to facilitate the management to control expenditure.
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Finance Department
 Preparation of cash flow statement.  Assessment of working capital requirements.  Assisting in purchase of equipment, raw material, and

laying down suitable procedures for purchase.  Advising the Chief Executive on the policies of prices of products, inter departmental issues etc.  Advise the management on all service matters having financial implications.  Organising an Internal Audit Department and processing the reports submitted by the internal Auditor, and placing them before the Board.

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Finance Department
 Ensuring that the annual accounts are prepared    

in time according to statutory audit and the audit by the Comptroller and Auditor General. Acting as custodian of the cash of the company. Furnishing management with prospective costs of the products to enable them to determine the optimum product etc. Preparation of quarterly reports on resources employed cash-flows, capital expenditure, profit & loss accounts and ratio analysis. Ensuring sound finance, non-finance interface.

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Investment Management
 Investment proposals are examined by various

agencies of the Government, including the Project Appraisal Division of the Planning Commission, the Department of Public Enterprises, the Public Investment Board, and the Cabinet Committee on Economic Affairs.

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Working Capital Management
 A number of enterprises do not have a well-defined

policy in regard to working capital management.  The Board of Directors is expected to determine the reasonable level of working capital, and review the position from time to time to ensure that the total investment in working capital is kept as low as possible.  PSUs could approach the State Bank of India, or any other nationalised bank to “finance their working" capital requirements. The working capital requirements of PSUs are generally met through cash credits and advances.  If necessary, the excess over the margin money could be covered by a guarantee from the Central Government.
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Working Capital Management
 Whenever the total requirements of the working capital

cannot be met by cash credit arrangements with the banks, the PSUs may approach the Government for short-term loans.  In special cases, non-plan loans are also advanced by the Central Government to some enterprises for meeting their working capital requirements.  For most PSUs, current assets exceed about six months' turnover. Some of the contributory factors to the excess build-up of working capital include its slow transmutation, unfavourable credit management, absence of motivation to reduce investment in different components of working capital, and lack of awareness concerning the current techniques to working capital management.
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Financing and Capitalization
 The Governments has been the main provider of both     

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 per cent of the total long-term investment needs. Foreign equity/loans account for more than 10 per cent of the long-term investment needs. Deferred credits took a lion's share of the foreign finance. Private participation from Indian business and investors is about 11 per cent of their total long-term resources. A major chunk of this amount has come in the form of bonds and public deposits.
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Financing and Capitalisation
 The capital structure in PSUs is formulated on

the basis of 1:1 debt equity mix suggested by the Government of India in 1961. Such a mix has been vehemently opposed by the PSU managers.  The issue of public participation in the equity of PSUs received the attention of the Estimates Committee of Parliament as early as 1955. The Committee recommended that at least 25 per cent of the capital of PSUs be made available for the public to secure their interest and cooperation in the management.
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Financing and Capitalisation
 The Krishna Menon Committee (1959) also

vehemently advocated public participation in the equity. The reasons given by the Committee for permitting private investments were
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it is a way of finding capital; it is a way of mopping up additional earnings of lower income groups; it is an anti-inflationary measure; and it enables members of (he community to participate in the profits of public enterprises.

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Financing and Capitalisation
 Public enterprises for a long time were not permitted

to approach the capital market to raise money through the flotation of debentures, public deposits and other securities.  In 1981, PSUs were allowed to approach the capital market to mobilize money through public deposits. On March 31, 2003, PSUs had raised Rs 21,017 crore through this  During the Sixth Plan period, some public enterprises were given permission to approach the foreign bond markets and to raise borrowings with limits provided under the category of external commercial borrowings

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Dividends Payments in PSUs
 PSUs pay normal dividends  In 1998–99, the dividends.declared were less

than 1 per cent 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 70 per cent of profits as dividends.  In 2002–03, the dividends declared measured up to 36.20 per cent of the net profits earned by the PSUs.
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Financial Controls
 Internal Audit  Budget and Budgetary Control  Line-Item Budgeting  Performance Budgeting  Programme Budgeting  Zero-Base Budgeting (ZBB)  Costing and Cost Control

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Line-item Budgeting
 Previous year's actual spending is

extrapolated for next year by adding a growth factor (generally for inflation).  The main advantage of line-item budget is the ease of its preparation; it makes a simple comparison of performance from one fiscal period to another fiscal period.  The main problem with this approach is the difficulty of relating the line budget to the goals of the parent organisation. Without much reviews, past inefficient activities are carried forward, making some resources wasteful.
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Performance Budgeting
 PB is a system of planning, budgeting, and

evaluation that emphasises the relationship between money budgeted and results expected. Common characteristics of a performance budget include
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Organisation's identification of mission, goals, and objectives, Linkage of strategic planning information with the budget, Development and integration of performance measures into the budget, and Disaggregation of expenditures into very broad areas (such as personnel, operating expenses, and capital outlays) rather than more specific line-items.
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Performance Budgeting–Advantages
 PB has more of a policymaking orientation. It connects     

plans, measures, and budgets. PB forces departments and policymakers to think about the big picture. PB provides better information about the impact of budget decisions on people. PB gives department's increased budgetary flexibility and incentives for generating budget savings. PB allows for ongoing monitoring to see if agencies are moving in the right direction. PB helps in developing unit costs for the activities. Activity-based costing may be applied under this approach.
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Performance Budgeting–Advantages
 PB strengthens legislative decision-making

and oversight,  PB enhances financial accountability to citizens, decision-makers, and governmental monitoring agencies, and  PB supports better management and evaluation.  Performance information can increase public accountability and public services. Furthermore, performance information provide decision-makers information they need for evidence-based policy-making.
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Performance Budgeting–Disadvantages
 The emphasis on quantity, not quality, of the

activity being monitored.  The link between performance measures and resource allocations are subject to political choices. There may also be lack of credible and useful performance information.  Difficulties may arise in achieving consensus on goals and measures.  There could also be dissimilarities in programme and fund reporting structure as well as the limitations of information and accounting system.
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Programme Budgeting
 Under a programme 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.  Agencies may be given incentives for performance that exceeds standards or disincentives for performance that falls below standards.
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Zero-Base Budgeting (ZBB)
 Zero-base budgeting (ZBB) is a budgeting

method for a corporation or government in which all expenditures must be justified afresh each year and not just amounts 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'.

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Process of ZBB
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Identification or redefining the mission and goals of the organisation. Identification of the organisation's 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.
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Applications of ZBB
 ZBB may be virtually applied to all government

departments, programs, schemes and activities.  In case of PSUs and private sector companies, ZBB is generally applied in the overhead area on which management has discretionary options or judgement.  However, ZBB is not applicable to direct production area which is better controlled through standard costing and industrial engineering techniques.  It is to be noted that a complete methodology of ZBB may not be applicable in certain situations and departments. As such, a Zero Base Review (ZBR) may be substituted for ZBB. ZBR is not so detailed as ZBB. It focuses on the review of the most critical activities.
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Benefits of ZBB
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Elimination of obsolete, non-relevant decision packages. Increased or decreased levels of funding for some decision packages and addition of new decision packages. ZBB encourages budget participation at the operating level. As a result, managers and employees become more focused. The comprehensive resource cost analysis process is a strong internal planning characteristic of ZBB. ZBB, when properly implemented, holds great promise for assisting personnel of an organisation to plan and make decisions about the most efficient and effective ways to use their available resources to achieve their defined mission, goals and objectives.
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Benefits of ZBB
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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. Useful for service department where the output is difficult to identify. Increases communication and coordination within the organisation. Managers and employees learn more about the organisation's activities and problems.
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Possible Problems
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Increase in paper work and time consuming. In certain areas of the organisation, 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.

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Possible Problems

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In the first year, cost of training, paper work and implementation of ZBB may go up because without its proper understanding, it can not be successfully implemented. Organisation 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 and politics.

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 In pursuance of the Arjun Sen Committee’s recommendations,

Memorandum of Understanding (MoU) in PSUs

the Government introduced the MoU in PSUs in 1987-88.  During the first few years of the introduction of MoU in the PSUs, the Government was guided by the French model of MoU which did not relate the performance to rewards. But, later on the Government of India switched over to the Korean Model of MoU which linked performance to incentives.  The basic philosophy guiding the MoU is to create an understanding between the government and the PSUs about the accountability of the latter to the former and 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 minimise the references that the PSUs were expected to make to the Government, on the one hand, and control that the Government would exercise on the PSUs to ensure their effective performance, on the other.
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Objectives of the MoU System
 Measure the performance of PSUs taking into

account the complexity effusing social and financial objectives and translating them into measurable parameters;  Ensure simultaneous increase in autonomy as well as accountability;  Set-up new institutions and administrative and personnel systems;  Replace 'multiply’ principles with multiple objectives' with clarity in goals and objectives.
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Structure of MoU
 The MoU is not merely a document, it is a way of life

or a management system. This tool for performance improvement incorporates within its fold three subsystem, namely, performance information system, performance evaluation system and performance incentive system.  Performance evaluation in MoU involves five steps. First three steps are taken at the beginning of the year and the last two steps are taken at the end of the year.

beginning of the year
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Step 1: criteria selection Step 2: criteria weight selection Step 3: criteria value selection Step 4: performance evaluation Step 5: performance reward
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at the end of the year
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Features of the PSU Financial Management
 Whereas in private enterprises the financing is done on 

  

long and short-term considerations, in PSUs this needs to be done keeping in view their stage of operation. The sources side of the balance sheet of PSUs reveals that these entities depend more on external resources, whereas their counterparts in the private sector have a tendency to depend more on internal resources. The use of current liabilities as a source of finance is less in PSUs as compared to the enterprises in the private sector. The cost of capital is at the back of every move in a private sector enterprise, whereas in PSUs it does not hold the position of that strength. The control mechanisms in PSUs are still evolving and have yet to take firm root.
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Features of the PSU Financial Management
 There are five main drivers for change in the

shape of the finance functions in PSUs:
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Intense competition. New opportunities, but also new risks. Increasingly onerous regulatory and environmental pressure. shareholders and stakeholder activism with social pressure often running a head of strictly legal requirements, influencing corporate governance. An entirely new attitude to quality and service regarded as an act of faith and often even transcending all financial calculations.
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