Group Income Statements of Qantas Airlines Ltd - Case Study Example

 Financial Analysis Introduction This report contains horizontal common- size analysis of group income statements of Qantas Airlines Ltd for the years 2007 and 2008 with 2006 as its base year. An analysis of the group balance sheets of the company has also been carried vertically for the years 2006, 2007, and 2008. Liquidity refers to short term solvency of any entity. Keeping this in view an in- depth liquidity analysis has also been undertaken in order to evaluate whether the company is able to meet its short term obligations when those become due. The write up also evaluates the Qantas’s ability to meet fixed finance costs and principle repayments of its long term debts. Finally the profitability trends of the company have been analyzed using ratio analysis method. 1. Horizontal common-size Group Income statement analysis Sales and other income have shown a rising trend, though increase in 2008 is comparatively less than the increase in 2007. As compared to base year 2006 the increase in 2007 was by 10.25 points (i.e., 110.25-100), which increase reduced to 8.28 points (i.e., 118.53-110.25) in the year 2008. The basic reason appears to be comparative less increase in net passenger revenue in 2008. Rise in expenditure in the year 2007 is of 108.24 points over base year of 2006 giving a rise of 8.24 points. This rise in expenditure has been effectively dwindled in the year 2008, when the index figure is 114.31 giving rise of 6.07 points. With such improved performance on expenditure front, the operating profits have been increased by 49.29 points in the year 2008 as compared to the rise of operational profitability of 47.44 points in 2007. The comparative better performance of operating profits in year 2008 is basically the result of improvement in expenditure despite the fact that rise in passenger revenue rise in 2008 was less than the rise in 2007. This performance is remarkable during the periods of credit crunch. The company has shown remarkable restrain on expenditures during 2008. This trend of increasing operational profitability is really appreciable looking at the trends of downfall of most firms in the airline industry. Profits before taxes and finance costs i.e. EBIT has shown a rise of 53.2 points in 2008 when this rise was only 34.46 in 2007. This remarkable increase is due to far sightedness of the company in dealing with derivatives that has given a boost to the financial cover of losses due to oil and other expenditures undertaken by the company. This is further appreciable as fall in oil price will have a major effect on the income statement of 2009 as compared 2008. The company has played its financial derivative investment cards effectively in enhancing the overall profitability along with improved efficiency in reduction of operational expenditure. That is why overall profitability during 2008 has increased by 61.86 points in 2008 as compared an increase of 40.17 points in 2007. This increase is after meeting the tax expenditure. All this has given a reason to smile to the equity investors in Qantas Airways Ltd. The earning per share, both basic and diluted, has shown tremendous increase in 2008 when compared to rise in 2007. The basic and diluted earning per share in 2008 has increased by 65.06 and 64.32 points respectively as compared to the comparative rise of 36.51 points and 37.1 points respectively in 2007. The company has done effectively well to maintain its equity base and this effect is certainly a long term measure to improve overall profitability of Qantas Airways in the years to come. Further the increased dividend declaration in 2008 has worked as icing on the cake for equity holders. The dividend declared in 2007 had a dismal effect as it decreased by 13.33 points. But that dampening effect of reduced dividend declaration has been more than covered up in 2008. The dividend declaration increased by 23.33 points in the year 2008. The company has performed tremendously well on profitability front. 2. Vertical common- size Group Balance Sheet analysis Total assets in an entity are financed by either by equity capital and/or debt capital. During 2006 68.37% of total assets were financed through debt capital and 31.7% were financed by equity capital. In other words Qantas Airways Ltd was a highly geared company so far as capital contributions are concerned. As per Graham Mott (page 198)i ‘Most firms use mix of borrowed and owners’ capital and the relation between the two is known as capital gearing. A company is said to be highly geared when it has large amount of borrowed capital relative to owners’ capital. It is lowly geared when the proportion of borrowed capital. Strictly speaking, gearing is the use of prior charge capital, including preference shares. Prior charge in this context means a prior charge against profit before equity.’ Even in years 2007 and 2008 debt capital constituted 71.07% and 70.89% of total capital resources. That clearly indicates that Qantas Airways has been highly geared all along over these years. High gearing has the effect of reduction of profitability for the equity holders as they are entitled to residuals of profitability and capitals after meeting all charges. But this at the same time also provides chance to equity holders to ‘trade in equity’. During the period of increasing profits the equity holders are highly benefited because of this trading in equity. Another feature of Qantas Airways balance sheet has come to the fore that total current assets are increasing year after year. In 2006 total current assets were 25.8% of total assets. It is observed that this percentage has increased to 28.66% and 28.51 respectively during 2007 and 2008. At the same time total current liabilities as constituent of total liabilities and equities are increasing at a faster rate than current assets during these years. In 2006 current liabilities were 28.29% of total liabilities and equities. This percentage has increased to 35.6% in 2007 and 38.6% in 2008. Current assets are constituent of working capitals that are normally used meet out current liabilities when those become due. When current asset fall short of current liabilities, as is the case here for Qantas Airways, current liabilities start using other resources that are meant for longer period liabilities of the entity. Qantas Airways is not managing its working capital in an effective way. The company is facing short term liquidity problems and facing the problems of meeting short term liabilities when those become due. Majority of total assets are invested in property, plant, and equipments. In the year 2006, 64.51% of total assets are invested in these fixed assets that are mainly responsible for passenger revenue, which is the main source of total revenue of the company. During 2007 and 2008 63.14% and 62.14% respectively of total assets are invested in property, plant, and assets of the company. Another noticeable feature of composition of assets of Qantas Airways Ltd. is investments in financial assets like derivatives. The percentage of investment is decreasing over the years. During 2006 the investments in financial assets was 4% of total assets and that has further reduced to 2.42% in 2007 and 1.76% in 2008. The reason appears to be dwindling economic and financial scenario in the markets and perhaps indications of reducing oil prices. This has made hedging a highly speculative proposal. 3. Liquidity Analysis Liquidity refers to the ability of a firm to meet its obligation in the short run, usually one year. Liquidity test is the test of short term solvency of the entity. This test can best be performed by two most popular ratios, namely current ratio and quick ratio. These ratios are generally based on the relationship between current assets (the sources of meeting short term obligations) and current liabilities. ‘Current ratio is a more dependable indication of liquidity than the net working capital.’(Linda Pinson, page 97)ii The current ratio measures the ability of the firm to meet its current liabilities- current assets get converted into cash during the operating cycle of the firm and provides the funds to pay current liabilities. Apparently, the higher the current ratio, the greater the short term solvency. However, in interpreting the current ratio, the composition of current ratio must not be overlooked. A firm with a high proportion of current assets in the form of cash and debtors is more liquid than the one with a high proportion of current assets in the form of inventories even though both the firms have the same current ratio. Internationally the current ratio of 2:1 is considered an optimum ratio for any type of industry. Qantas Airways has current ratio of 0.91:1, 0.4:1, and 0.4:1 in 2006, 2007 and 2008 respectively. This ratio is much below the required current ratio of 2:1 which is considered optimum under any circumstances. Comparing with this internationally approved standard, the Qantas Airways has been keeping liquidity much below that is required to maintain short term solvency. This is a clear indication that Qantas Airways has been facing great liquidity problems and it might not be always easy for the company to meet its short term obligation when those become due. Qantas Airways need certain concentrated measures to improve its liquidity. There is another ratio called quick ratio (also called acid test ratio) that helps in measuring liquidity of a firm. Quick assets are defined as current assets excluding inventories. The acid test is fairly stringent measure of liquidity. It is based on those current assets which are highly liquid. That is why inventories are excluded from current asset to calculate quick ratio. Internationally the quick ratio of 1:1 is the fair standard for any type of industry. In the case of Qantas Airways, this ratio is calculated in annexure as 0.85:1, 0.39:1, and 0.38 for 2006, 2007 and 2008 respectively. This ratio again, like current ratio, is much below the required standard of 1:1. The indication is very clear. Qantas Airways Ltd. is in trouble so far as liquidity position is concerned. It will be seen that inventory portion in total current assets have increased in 2008 when compared with 2007. In 2007 the inventories were 0.92% of total assets which increased to 1.09% of total assets in 2008. The company needs to put efforts to add more current assets that are easily convertible into cash. Only with improvement of quick ratio the Qantas Airways Ltd. will be able to come out of its liquidity crisis. Entire airline industry is facing credit crisis of the manner that is affecting the revenue collections of the firms in industry. But fortunately Qantas Airways Ltd. is placed in a better position than other firms in the industry in the sense that its revenue is showing an increasing trend. This is a good sign that can help the Qantas Airways to improve its liquidity by making more concentrated efforts to add to more liquid assets. 4. Long Term Debt paying ability Long term paying ability is concerned with long term solvency of the firm. Long term solvency of a firm can be tested from the judgment of the firm’s ability to pay the interest and principal on the long term debt liabilities of the firm. There are two ratios that measure this long term ability of the firm to meet the interest and principal of ling term liabilities. The one ratio is called ‘Time interest earned ratio’ and the other ratio is ‘Debt equity ratio.’. Time interest earned ratio is also called the ‘interest coverage ratio’. This ratio measures the ability of the firm to meet contractual interest dues on long term debts. Earning before the interest and taxes reflects the amount available to a firm to meet its interest liability. The higher the ratio, the better is the capacity of the firm to meet its interest liability. Time interest earned ratio calculated in the annexure reveals this ratio as 3.33 times, 3.83 times, and 5.7 times for 2006, 2007, and 2008 respectively. This ratio is showing an increasing trend because of improving operating profits of Qantas Airways Ltd. This is certainly a good trend and shows the increasing strength of the company to meet its liability on long term debts of the company. In fact the year 2008, which has been considered a difficult year for airline industry, the firm has shown a tremendous improvement in earnings before interest and taxes. EBIT has increased in 2008 by 53.2 points as per horizontal common size analysis as compared to 34.46 points in 2007 compared with reference to base year of 2006. This has improved the position of Qantas airways to meet its ability to meet the interest liability on long term debts. It is very important to note that ‘typically higher coverage ratios are preferred, but too high a ratio(above industry norms) may result in unnecessarily low risk and return. In general, lower the firm’s coverage ratios the less certain it is to be able to pay fixed obligations. If a firm is unable to pay these obligations, its creditors may seek immediate repayment, which in most instances force a firm into bankruptcy.’(Lawrence J Gitman, page 64)iii Debt Equity ratio reflects any firm’s long term ability to pay the liability of principal repayments of long term debts. In general the lower the debt equity ratio, the higher the degree of protection enjoyed by the creditors. In using this ratio as a measure of the ability of the firm to pay principle repayments of long term debts, consideration of following points is very important: In case assets are carried at their historical values less depreciation and not at current values, the book value of equity may be an understatement of its true value in a period of rising prices. Some forms of assets (like term loans, secured debentures, and secured short term bank loans) are usually protected by charges on specific assets and hence enjoy superior protection. Debt equity ratios as calculated in the annexure for Qantas Airways Ltd. are0.56, 0.55, and 0.53 for 2006, 2007, and 2008 respectively. As the ratio is marginally more than 50% in all the three years, it can be said that repayment of principal portion of debt may be less than secured as the position is not indicating a comfortable. At the same time the ability of the firm to repay principal is not bad either. But Qantas Airways must make efforts to bring the level of debt ratio down below 50% or at a position where the capital structure is not highly geared. 5. Profitability Assessment Ratios used to analyze the profitability of Qantas Airways are Operating Profit Margin, Net Profit Margin, Return on Total assets employed, and Return on equity employed. Operating profit margin ‘measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividend are deducted. It represents the pure profits earned on each sales dollar.’(Lawrence J Gitman, page 67)iv Qantas has earned operating profit margins at the rate of 5.11%, 6.84%, and 8.48% during the year 2006, 2007, and 2008 respectively. The operating profits are rising over the years mainly because of increasing passenger revenue and the efficiency shown by management in controlling the expenditure. This is a remarkable performance during the prevalent credit crisis in the later year of periods under consideration. Net profits are the profits remaining after meeting all liabilities of interest and taxation. Qantas has achieved net profit of 3.51%, 4.47%, and 5.99% respectively during 2006, 2007, and 2008. Qantas’s net profit margin is increasing year after year. This shows that even after meeting the fixed liabilities of finance cost and taxation, the company is showing an encouraging performance. ‘Return on total assets points to the efficiency with which management has employed its resources to obtain income.’ (Joel G Siegel and Jae K Shim, page 245)v. Return on assets not only represents the efficiency of entity in handling assets to generate profits, but indicates the potential efficiency of assets installed or employed in generating profits. This time also Qantas Airlines Ltd. has an increasing trend of Return on assets employed. In the year 2006 ROA was 2.5% and that increased to 3.45% in 2007, and 4.92% in 2008. The performance is tremendous on the part of Qantas Airlines Ltd. Return on equity is a measure that reflects the returns on capital invested by equity holders. This profitability ratio encourages intended investments by the prospective investors. The company has earned 7.89% in 2006, 11.93% in 2007, and 16.91% in 2008. Such figures are definitely going to bring more investors for Qantas Airlines ltd. Overall Qantas Airlines ltd. has performed extremely well in defining the profitability for the company year after year. The performance during the period under consideration is tremendous and speaks a lot about the efficiency and hard work of the management. 6. Finding and Analysis Horizontal analysis of income statement reflects that Qantas Airlines Ltd. has shown an encouraging performance with 2006 as base year of measurement. Profitability has shown increasing points due to increasing revenue and controlled expenditure resulted from the efficient management performance. Vertical analysis reflects that the company is highly geared as more of debt capital is employed in financing the total assets of the company. The company’s current assets are not rising in comparisons of the increasing current liabilities. The company is facing liquidity problems. The company’s short term solvency is being challenged by low current ratio and also inefficient quick ratio. The company has to take stringent measures to improve its liquidity in order to maintain its creditability among its creditors. The company is strong enough to meet its interest payment commitments on its long term debts. Though there is no panic so far repayments of principal amounts of long term debts, but the company has to improve upon its capital structuring in order to meet these principal repayments of long term debts. The company is showing highly encouraging profitability trends over the years. Potential investors will be encouraged because of efficient management of total assets and other resources employed. Word Count: 3071 Annexure: Horizontal common-size Group Income statement analysis Vertical common- size Group Balance Sheet analysis Ratio Calculations References Read More