A Case study on: Disinvestment of Public Sector Undertakings in India – An Impact Study By Pankaj Kumar Enrolment No: 10810041 MBA Batch 2010 – 12 DoMS IIT Roorkee Referenced from: Indian Journal of Finance August 2010 Authors: Dr. M. K. Ramakrishnan and Sandhya R. Introduction: In a mixed economy like India, historically the public sector had been assigned an important role.
However, in the year 1991 the national economic policy underwent a radical transformation. The new policy of liberalization, privatization and globalization de-emphasized the role of the public sector in the nation’s economy.Privatisation in India generally goes by the name of “disinvestment” or “divestment of equity”. Disinvestment is a wider term extending from dilution of the stake of the Government to a level where there is no change in control to dilution that results in the transfer of management. The policy of promoting PSU’s took a paradigm shift with the announcement of industrial policy on July 24th 1991, in which the central government expressed its intention to bring the private sector participation through a system of disinvestment of PSU’s except in arms and ammunitions and allied item of defence equipment, atomic energy and minerals.It is contended that the functioning of many public sector units (PSUs) has been characterized by low productivity, unsatisfactory quality of goods, excessive manpower utilization, inadequate human resource development and low rate of return on capital. For instance, between 1980 and 2002, the average rate of return on capital employed by PSUs was about 3.
4% as against the average cost of borrowing, which was 8. 66%. This prompted the Government to adopt a new strategy keeping in line with the global trends to reform and improve the PSU’s performance.In the first round of divestment, the Government offered bundles of shares of various PSU’s (each bundle carrying notional reserve price) to local financial institutions.
Later the bidding process was opened to foreign investors and the public at large. The method of disinvestment was widened in 1996-97 when disinvestment was affected through both the GDR (Global Depository Receipts) route and public issue in the domestic market. After initial round of disinvestment in 1991-92, it was further guided by recommendation made by a committee on Disinvestment set up in 1993.Later, realizing the sensitivity in political terms of whole process, the government constituted in 1996, an independent body called “The Disinvestment commission”. The disinvestment commission was asked to advice on such matters as to the extent of disinvestment, mode of disinvestment and selection of financial advisor to facilitate the process and so forth to strengthen the disinvestment program.
The two methods of disinvestment form the backbone of the disinvestment strategy of the Government. They are minority sale and strategy sale.The difference between two mode lie with the extent of dilution of control in PSU’s.
Strategic sale involves transfer of control to private entrepreneurs where as minority sale involves dilution of government stake without transfer of control. The early period (i. e. 1991 to 1999) of privatisation was marked by only minority sale. It took 10 years to introduce strategic sale into disinvestment strategy. This clearly shows conservative approach of the Government in the implementation of disinvestment policy.Disinvestment involves the sale of equity and bond capital invested by the government in PSUs. It also implies the sale of government’s loan capital in PSUs through securitization.
However, it is the government and not the PSUs who receive money from disinvestment. The fixation of share/bond price is an important aspect of disinvestment. Now, the Disinvestment Commission determines the share/bond price. Disinvested shares are listed, quoted and traded on the stock market.Indian and foreign financial institutions, banks, mutual funds, companies as well as individuals can buy disinvested shares / bonds Disinvestment is generally expected to achieve a greater inflow of private capital and the use of private management practices in PSUs, as well as enable more effective monitoring of management discipline by the private shareholders. Such changes would lead to an increase in the operational efficiency and the market value of the PSUs.
This in turn would enable the much needed revenue generation by the government and help reduce deficit financing. Methodology and Data Used:This case study is based on the fundamental analysis of financial information from published sources. Accounting ratios are extensively used to study the financial performance of the target companies. Statistical tools were also used to summarize and interpret the results of the study. The ratios used in the present analysis will measure the financial performance from three angles. They are Profitability, Liquidity and resource Utilization levels. The study pertains to a period for 5 years from 2003 to 2008.
Financial year 2003-04 is taken as the base year (pre disinvestment period) in which disinvestment of the company was completed.A period of 4 years that is 2004-05 to 2007-08 represents post disinvestment period. The performance of the companies in that period was compared with the base year to fulfil the objective of the case study. This case study includes the study of two company representing minority sale i. e. Dredging corporation of India limited (DCIL) and Gas Authority of India Limited (GAIL) and one company representing majority sale is Hindustan Zinc Ltd (HZL). Analysis of Profitability 1.
Net Profit Ratio: It establishes relationship between net profit and sales.It indicates the efficiency of the company in manufacturing, administration, selling and other core business functions. Net Profit Ratio Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 21| 21| 21| Post Disinvestment| 2004-08| 19. 63| 42. 75| 31. 19| CAGR (%)| | -1. 68| 19.
45| 10. 39| Source: Compiled from financial statement| The study revealed that disinvestment has caused improvement in profitability of enterprises. The average profitability of disinvested companies has grown at compounded annual growth rate (CAGR) of more than 10% in the post disinvestment period.The improvement is more significant in case of strategic sale.
2. Return on capital employed (ROCE): It measures return in terms of profits before interests and taxes (PBIT) as a function of the total capital employed. Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 23. 5| 27| 25. 25| Post Disinvestment| 2004-08| 21. 25| 56| 38. 625| CAGR (%)| | -2.
48| 20| 11. 21| Source: Compiled from financial statement| ROCE is a product of net margin and the efficiency in which the assets are managed. In the post disinvestment period, the combined profitability of disinvestment entity has recorded a CAGR of 11.
1 percentage points. 3. Earnings per share (EPS): This shows the earning potential of the company from the point of view of equity shareholders. This establishes the relationship between earnings as a function of the no. of equity share in the issue.
Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 41| 10| 25. 5| Post Disinvestment| 2004-08| 41. 75| 104| 72.
875| CAGR (%)| | 0. 45| 79. 58| 30. 02| Source: Compiled from financial statement| The above table depicts that the average CAGR on EPS has increased by 30% in post disinvestment period.Further strategic sale is again more significant in term of mode of disinvestment. Analysis of Liquidity 1. Current ratio: It measures the relationship between two primary elements of liquidity: current asset and current liability. It measures the firms’ ability from short term liability to short term assets.
Current assets are all asset classes that are converted into cash within a period of one year and current liabilities are those liabilities that are repayable within a year. Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 0. 33| 1. 36| 0.
45| Post Disinvestment| 2004-08| 2. 0925| 1. 2375| 1.
665| CAGR (%)| | 58. 68| -2. 33| 18.
47| Source: Compiled from financial statement| The short term liquidity of company has increased substantially since disinvestment as indicated by average CAGR of 18% on current ratio. 2. Cash Flow From Operation to current liabilities: One of the objective of the financial management is to optimize cash flow from operations. In the absence of adequate supply of cash flow from operation (CFFO), a company will have to find non operating sources to maintain liquidity and level of operations.This is an important complement to the current ratio since it demonstrate whether or not the business needs to generate funds from non trading sources in order to meet short term obligations. The adequacy of cash flow from operation is a more precise measure of liquidity when it is compared with the current liabilities of the firm.
Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 0. 53| 0. 54| 0. 535| Post Disinvestment| 2004-08| 0. 195| 2. 56| 1. 3775| CAGR (%)| | -22.
12| 47. 55| 26. 67| Source: Compiled from financial statement|The above table clearly shows that disinvested has boosted the cash flow of generating capacity of companies. In post disinvestment period, it has increased to 1. 37 registering a CAGR of 27%.
3. Debt equity ratio: It measures extent to which debt financing has been used in the business. The ratio indicates the proportional claims of owners and outsiders against the firms’ asset. Debt ratio measures financial leverage of a firm. Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 0. 19| 0.
40| 0. 295| Post Disinvestment| 2004-08| 0. 1025| 0. 11| 0. 1075| CAGR (%)| | -14. 0| 27. 18| -22.
30| Source: Compiled from financial statement| The lower debt equity ratio indicates the reduced financial risk exposure of these companies. It is evident that the debt component of the disinvested companies has reduced in the post disinvestment period as indicated by the negative CAGR of 22%. Analysis of asset utilization 1. Debtor turnover ratio: This indicates the velocity of debt collection of a firm, a factor contributing to the movements in operating cash flows.
It measures collection efficiency of the firm. Debtors turnover in Days = (Average Debtors/Total Credit sales)*100Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 59| 29| 44| Post Disinvestment| 2004-08| 71| 31| 51| CAGR (%)| | 4. 74| 1. 68| 3.
76| Source: Compiled from financial statement| The collection period of disinvested entities on an average has increased in the post disinvestment period from 44 days to 51 days. Thus, it is evident from table that disinvestment has caused decline in collection efficiency of firms. 2. Inventory Turnover Ratio: This measures the velocity of conversion of stock into sales. It indicates whether inventory has been efficiently used or not.It evaluates the efficiency with which a firm is able to manage its inventory. Inventory days = (Average Inventory/ Cost of goods sold) * 365 Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 15| 124| 69.
5| Post Disinvestment| 2004-08| 16| 92| 54| CAGR (%)| | 1. 63| -7. 19| -6. 11| Source: Compiled from financial statement| It is evident from the table that the inventory management efficiency has improved during the post disinvestment period as indicated by the decrease in inventory days from 69. 5 to 54. Usually a low inventory period indicates the efficient management of inventory. .
Working Capital Turnover: This indicates the velocity of utilization of net working capital. This ratio indicates the number of times the working capital is turned over in the course of a year. Higher the ratio, the better will be the utilization of working capital and the resulting operating cash flows. Working capital Turnover Ratio= Total Sales/ Net Working Capital Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 22| 14| 18| Post Disinvestment| 2004-08| 6. 13| 24. 25| 15.
19| CAGR (%)| | -27. 36| 14. 72| -4. 16| Source: Compiled from financial statement|The average working capital efficiency has declined marginally in the post disinvestment period where as strategic sale helped to improve working capital efficiency. 4. Fixed Asset turnover ratio: This measure the efficiency in the utilization of funds tied up in this form of assets. It establishes the relationship between net fixed capital investment and the corresponding sales revenue. Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 1.
34| 2. 06| 1. 76| Post Disinvestment| 2004-08| 1. 61| 2. 37| 1. 9875| CAGR (%)| | 4.
69| 3. 51| 3. 98| Source: Compiled from financial statement|It is evident from the table that the companies have improved their fixed asset utilization levels after disinvestment by the CAGR of 3. 98%. Altman Z-score model: Altman developed a multivariate Z-score model to study the financial distress of public companies whose shares are listed in the stock exchanges. This model shows the combined impact of all the aspects of financial performance on the overall financial health of target companies. The model is expressed as follows: Z = 1. 2(X1) + 1.
4(X2) + 3. 3(X3) + 0. 6(X4) + 1(X5) Where: X1: Working Capital / Total assets X2: Retained earnings/ Total assetsX3: Earnings before interest and Taxes/ Total assets X4: Market value of equity/ total liabilities X5: Sales/ Total assets A Z- score below 1. 81 indicates high profitability for bankruptcy or financial distress. A score above 2. 99 indicates a low profitability for bankruptcy.
A score between 1. 81 and 2. 99 indicates grey areas where managerial actions needed to improve the financial health of the firm. Time Frame| | Minority sale| Strategic sale| Average| Pre Disinvestment| 2003-04| 2. 88| 2. 31| 2. 595| Post Disinvestment| 2004-08| 2.
91| 4. 95| 3. 93| CAGR (%)| | 0. 26| 20. 99| 10.
93| Source: Compiled from financial statement|Even though the financial health of the target company has increased after disinvestment, the comparative analysis clearly highlights the impact of the mode of disinvestment on the overall financial health reflected through the Z score. The average Z- score of the companies has increased marginally from 2. 88 to 2. 91 whereas Strategic sale has clocked 20.
99% CAGR in Z score where as counterparts minority sale clocked only . 26% CAGR. This clearly supports the results of many of the foregoing analysis relating to liquidity, profitability and asset utilization aspects of target companies performance in the post disinvestment period.Conclusion: The study examined the financial performance of companies from liquidity, profitability and asset utilization dimension of financial performance. The study reveals that disinvested entities generally improved their performance in all three aspect of financial performance in the post disinvestment period.
Disinvestment through Strategic sale has achieved remarkable progress in all three aspect of financial performance than their counterparts representing minority sale. The Z score analysis based on Altman model also supports this finding of the study.Thus, it can be concluded that though disinvestment is likely to cause improvements in financial performance, the mode of disinvestment is an important factor affecting the financial performance.
The strategic sale mode of disinvestment provides company more freedom and opportunities to carry our structural changes for achieving rapid growth and to improve their competiveness. Since Strategic sale involve transfer of control from government to private entrepreneurs, such decisions will definitely affect stakeholders’ interests. The mode of disinvestment successful in one situation or time may not yield similar results in other context.This requires clarity as well as consensus in objectives of disinvestment. For instance, PSU’s which are exposed to high level of completion and technology changes; disinvestment through strategic change will yield better result than minority sale.
Minority sale on the other hand, will bring positive result where level of completion is low or the impact of environmental factors is relatively stable or predictable. One of the challenges of disinvestment faced by government is resistance from employees and other stakeholders group. The resistance can be managed by partially preferential allotment of equity capital to the employees.
The timing of disinvestment is also critical for maximizing the proceeds of disinvestment. Hence the disinvestment requires strategy and government should take utmost care in timing and choosing the mode of disinvestment in order to realize maximum results from the disinvestment. Q & A 1Q. Why government of India is promoting disinvestment of public sector undertaking? A. It is contended that the functioning of many public sector units (PSUs) has been characterized by low productivity, unsatisfactory quality of goods, excessive manpower utilization, inadequate human resource development and low rate of return on capital.For instance, between 1980 and 2002, the average rate of return on capital employed by PSUs was about 3. 4% as against the average cost of borrowing, which was 8. 66%.
This prompted the Government to adopt a new strategy keeping in line with the global trends to reform and improve the PSU’s performance. Disinvestment is generally expected to achieve a greater inflow of private capital and the use of private management practices in PSUs, as well as enable more effective monitoring of management discipline by the private shareholders. Such changes would lead to an increase in the operational efficiency and the market value of the PSUs.This in turn would enable the much needed revenue generation by the government and help reduce deficit financing. 2Q. What are the major challenges for government of India to introduce disinvestment? A. First major issue is multiple objectives.
PSUs were often not designed to be primarily profit-making enterprises. They were expected to promote social objectives such as generating guaranteed employment, taking industries to backward areas, buying inputs from other PSUs to support them, providing output at reasonable prices to people, irrespective of costs, and so on.Their performance was not to be judged by commercial profitability. Apart from the confusion created in the minds of managers as to what goals to be given priority, it provided convenient excuses to hide inefficiencies. A manager of a perennially loss-making PSU can always claim to be promoting `social’ profits. Second challenge is multiple-control authorities. Unlike the private sector manager, the public sector manager is subject to control and scrutiny by different ministries, the Bureau of Public Enterprise, various parliamentary committees and investigating agencies.
Result: Status quo is the safest option for the manager.No bold decision on modernisation, diversification or technological upgradation is taken. For instance, automation may displace labour, and changing the supplier may disturb the existing patronage system. The promotion and career prospects of the manager are not usually linked to his dynamism or entrepreneurship and often have more to do with keeping his political bosses in good humour. The basic problems lie in the nature of ownership and the consequent incentives. State ownership is ownership by an impersonal legal entity called state. Since it is owned by everybody, it is owned by none.Social control boils down to control by politicians and bureaucrats.
Often, state-owned units are headed and managed by politicians and civil servants, rather than professional mangers, as chairmen or managing directors. 3Q. Why sell to private strategic investors? A. It is evident from the analysis of accounting ratio made in this case study that strategic sell mode of disinvestment is more profitable than the minority sale. The strategic sale mode of disinvestment provides company more freedom and opportunities to carry our structural changes for achieving rapid growth and to improve their competiveness.Since Strategic sale involve transfer of control from government to private entrepreneurs, such decisions will definitely affect stakeholders’ interests.
It is only by selling, controlling interest to one major private investor who has the funds and the expertise to manage and, if necessary, restructure the company that the government can hope to get the best possible price. An investor would be willing to pay the maximum only when he gets effective control, and that sets the market price. Divestment through retail sales can take place simultaneously, but not as a substitute.