Divestment
The sale of an existing business or an asset class that doesn’t perform or meet the expectations of the company or a country
What is Divestment?
Divestment is the sale of an existing business or an asset class that doesn’t perform or meet the expectations of the company or a country. Divestment is also referred to as divestiture.
Summary
- Divestment is the sale of an existing business or an asset class that doesn’t perform or meet the expectations of the company or a country.
- It helps organizations to generate cash, thereby reducing debt and making the company more attractive with a low debt-to-equity ratio. It also helps companies to focus their attention on their core business activities.
- Divestment, unlike business acquisition, comes with a strict time constraint accounting and operational complexities for the selling company.
Reasons for Divestment
Divestment is a difficult decision for a business. However, there are many reasons why a company would divest an asset or a subsidiary company. Below are some of them:
1. Source of funds
In times of financial difficulty and to keep the business afloat, businesses sell off their non-core assets. Instead of investing their money in a subsidiary or unit that is performing poorly, businesses will sell the assets and save money to prevent insolvency.
For example, CSX Corporation, a real estate and rail transportation company, made divestitures to focus on its core railroad business and also to obtain funds to settle its existing debt.
2. Focus on primary business
In the 1980s, the takeover of small businesses by larger organizations became a trend, despite being from a different industry. Companies realized that handling non-core assets were hampering their core operations. Nowadays, companies sell off non-related units and focus their attention on their core operations.
For example, Kodak, Ford Motor Company, and many other companies sold various businesses that were not related to their core businesses.
3. Prevention of monopoly
In many countries, the government mandates divestments to avoid a monopoly and to maintain fair trade practices. Hence, companies divest to abide by the rules.
For example, in the 1980s, American telecommunication company AT&T monopolized the U.S. telecommunications industry. The US government forced AT&T to divest itself by selling off assets, thereby allowing other companies to enter the market.
4. Better investment opportunities
The primary objective of any business is to generate profits, and that can be possible if they seize any opportunity that comes their way. Consequently, a company may divest a not-for-profit business unit to one that promises a higher rate of return at the same amount of investment in the future.
5. Social or political reasons
Companies will often divest from regions that are experiencing war-related or socio-political tensions. When companies divest from such regions, there is an outflow of cash from the war-torn countries. By doing so, companies force the current regime to quit and bring in a democratic government that will ensure the well-being of its citizens.
For example, in the 1990s, companies like PepsiCo, HP (Hewlett-Packard), and Macy’s protested the military-ruled government in Myanmar. The companies were encouraged by the opposition to invest once a democratic government was elected.
Challenges Faced During Divestment
Divestment is typically a more labor-intensive process than acquiring a new business. While business acquisitions can take as long as needed, a divestment comes with strict time constraints.
It is because the process involves extensive planning and the speedy execution of the divestment from the seller before the transaction closes. It also requires the seller to handle the marketing and selling of the divested entity at the same time.
1. Operational challenges
The finance department of the selling company is a significant contributor to the operational side of the divestment. Their primary function in the process is to measure the effects on the company’s bottom line (net profits or net earnings). Hence, accurate record-keeping and financial reporting are necessities for a successful divestment.
2. Carve-out financial statements
One main task of the selling company is to prepare the “carve-out” financial statements. A carve-out entity is an entity or subsidiary that is being divested. The U.S. Securities and Exchange Commission (SEC) requires that the statements represent the divested company and also show the cost of conducting the business.
3. Accounting complexities
Several accounting tasks must be completed before the divestiture can take place. For example, one metric that needs to be calculated is the portion of the divested company’s debt that needs to be allocated to the parent company and other third parties. They must also establish the capital structure of the divested entity.
Additionally, if the divested companies’ financial statements are to be audited, then the parent company needs to ensure that the auditor’s conclusions are in sync with those of the company’s management.
Related Readings
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:
