CH 36

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 zero-
base budgeting and performance budgeting to
government companies.
Financial Management, Ninth Edition © I M Pandey 2

Vikas Publishing House Pvt. Ltd.
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.
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.
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.

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.

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.

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.

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.

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.
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.
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.

 The Krishna Menon Committee (1959) also
vehemently advocated public participation in the
equity. The reasons given by the Committee for
permitting private investments were
 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.

 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

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.

Financial Controls
 Internal Audit
 Budget and Budgetary Control
 Line-Item Budgeting
 Performance Budgeting
 Programme Budgeting
 Zero-Base Budgeting (ZBB)
 Costing and Cost Control

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.
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
 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.
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.

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.
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.
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.

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'.

Process of ZBB
 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.
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.
Benefits of ZBB
 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.
Benefits of ZBB
 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.

Possible Problems
 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.

Possible Problems
 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.

Memorandum of Understanding
(MoU) in PSUs
 In pursuance of the Arjun Sen Committee’s recommendations,
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.
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.

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 sub-
system, 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
 Step 1: criteria selection
 Step 2: criteria weight selection
 Step 3: criteria value selection
 at the end of the year
 Step 4: performance evaluation
 Step 5: performance reward
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.
Features of the PSU Financial
Management
 There are five main drivers for change in the
shape of the finance functions in PSUs:
 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.

CH 36

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Chapter - 36

Financial Management, Ninth Edition © I M Pandey 2

Financial Management, Ninth Edition © I M Pandey 5

Financial Management, Ninth Edition © I M Pandey 6

Financial Management, Ninth Edition © I M Pandey 7

Financial Management, Ninth Edition © I M Pandey 8

Financial Management, Ninth Edition © I M Pandey 9

Financial Management, Ninth Edition © I M Pandey 12

Financial Management, Ninth Edition © I M Pandey 13

Financial Management, Ninth Edition © I M Pandey 14

Financial Management, Ninth Edition © I M Pandey 15

 Costing and Cost Control

Financial Management, Ninth Edition © I M Pandey 16

Financial Management, Ninth Edition © I M Pandey 19

Financial Management, Ninth Edition © I M Pandey 22

Financial Management, Ninth Edition © I M Pandey 23

Financial Management, Ninth Edition © I M Pandey 27

Financial Management, Ninth Edition © I M Pandey 28

Financial Management, Ninth Edition © I M Pandey 29

Financial Management, Ninth Edition © I M Pandey 31

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