The Financial Statement Analysis of the Southwest Airlines - Case Study Example

Finance Table of Contents Analysis 3 Comparison with the industry 7 Recommendation 7 Reference 9 Bibliography 12 Annexure- 13 Introduction The financial statements of a company offer an insight into the performance and management of the business affairs. Ratios can be constructed using the annual reports of the company. These ratios can then be used for inter-company comparison to evaluate the performance of the company. It can also be compared with those of the previous years to observe the trend in its performance. The main ratios are liquidity ratio, profitability ratio, leverage ratio and turnover ratio (Washington State University-b, n. d.). Analysis The coverage ratio of the company measures the ability of the company in meeting its obligations (Drake, n.d.). In the financial year 2008, Southwest Airlines paid $130 million as interest expense and in this year the company earned Earning before interest and tax (EBIT) of $278 million. This gives an interest coverage ratio of 2.13 times. This means that the earnings of the company are sufficient for meeting two times the interest burden. The interest expense of Delta Airlines is $705 million and the company has a negative EBIT of $8336 million. From this it can be inferred that the earnings of the company are not sufficient of taking care of its interest obligations. An interest coverage ratio less than 2 indicates financial risk (Massachusetts Institute of Technology, n.d.). Although the interest coverage ratio of Southwest Airlines is not very high but this is fairly good as compared with Delta Airlines. The current ratio of Southwest Airlines is 1.03 as compared to 0.80 of Delta Airlines. This is can be interpreted as in the year 2008 the former had $1.03 for one dollar of short term liability. This is fairly good as compared to Delta Airlines which had only $0.80 for every one dollar of short term liability. From this it is clear that the liquidity position of the former is better as compared to Delta Airlines (Washington State University-a, n. d.). The debt-equity ratio of Southwest Airlines is 1.37 whereas the same for Delta Airlines is 50.5. This implies that the latter has high level of debt exposure as is evident from its total debt position of $44140 million. The debt of Delta Airlines is nearly 7 times the total debt of Southwest Airlines. Due to its high leverage the former is very risky. Moreover Delta Airlines is making huge losses and the company is not capable of bearing such heavy debt burden (Leonard Damodaran, n. d.). The debt to asset ratio of Southwest Airlines is 0.44 implying that 44% of its assets are financed by debt whereas the same for Delta Airlines is 0.98. This shows that the latter has financed 98 percent of its assets out of debt. It has very little equity reliance as is evident from its total equity position of $874 million which is nearly one-fifth of the total equity of $4593 million of Southwest Airlines. This is indicative of Delta Airline’s excessive usage of debt for financing the assets. The net income of Southwest Airlines is $178 million. For the year 2008, the revenue earned by the company is $11023 million; whereas the revenue earned by Delta Airlines is $22697 million which is nearly twice the revenue earned by Southwest Airlines. Even then the latter is earning a net loss of 8922 million. Southwest Airlines has earned a net profit margin of 1.61% for the year 2008 but this margin for the Delta Airlines is negative at -39.3%. Despite the revenue of the former being less than the latter it has managed to earn a positive net profit margin which highlights the efficient management of the company’s administrative and operating expenses. Amidst the financial crisis of 2008 when all the other companies in the industry are earning a net loss, Southwest has managed to earn a positive net income margin highlighting its efficiency of operations (Yahoo Finance-a, 2010; Yahoo Finance-b, 2010). Southwest Airlines earned a return on equity of 3.87% for the financial year ending 2008. In this year when most of the airlines like Delta Airlines and AMR Corporation have failed to earn profit even at their operating level Southwest Airlines has managed to achieve a surplus return for its equity investors. This highlights efficient management of the company operations. Even though the equity base of Southwest Airlines is five times the equity base of Delta Airlines still it has managed to earn a positive return for its shareholders. On equity base of $874 million Delta Airlines is earning a net loss of $8922 million. This indicates that the company as failed to create any wealth for its shareholders. The return on asset (ROA) is expressed as Net profit /Total assets. A high return indicates efficient resource management. Southwest Airlines has deployed assets worth $14308 million in the business which is nearly one-third of the total asset base worth $45014 million of Delta Airlines. On this limited asset base Southwest Airlines is able to earn a positive return of 1.24% as compared to Delta Airline’s negative return on investment. This indicates that the former has efficiently managed its assets. Even on a low asset base it has earned a positive return whereas Delta Airlines earned a negative return of 19.82% on its asset base. The asset turnover ratio is obtained by dividing the revenue of the business by the assets. A high asset turnover ratio is a good sign and indicates that the company is managing its assets effectively. Southwest Airlines has an asset turnover ratio of 0.77 as compared to 0.50 for Delta Airlines. The total revenue of $22697 million earned by the latter is double the total revenue earned by the former. But the latter has earned this revenue on an asset base that is nearly three times the asset base of Southwest Airlines. This signifies the inefficient asset utilization of Delta Airlines. Despite the high assets its asset turnover ratio is significantly less at 0.50. For restoring the asset turnover ratio to higher levels it can either increase its revenue or dispose of the surplus assets (Ross, et al., 2004). The operating ratio of a company is expressed as Operating expense/Net Sales. It highlights the efficiency of the company in managing its expenditure. Southwest Airlines has incurred an operating expenditure of $10574 million and generated revenues worth $11023 million whereas Delta Airlines has incurred an operating expenditure of $31011 million and generated sales worth $22697 million. The operating ratio of the former is 0.95 as compared to 1.36 of the latter. A low operating ratio is desirable as it signifies that the company has to spend less per unit of sales whereas a high operating ratio indicates the management’s inefficiency. The operating ratio of Southwest Airlines is less than one signifying that the company’s management has exercised good control over its operating costs. However the operating expenditure incurred by Delta Airlines is more than the revenue generated by it indicating inefficiency in controlling costs. In terms of this ratio Southwest Airlines is better placed than Delta Airlines. Comparison with the industry The financial year 2008 presented a number of challenges to the airlines industry. Global recession and falling demand made it increasingly difficult for the companies to operate. However Southwest Airlines managed to weather these conditions better than most of its peers. Even in this turbulent year the company managed to retain consecutive yearly profitability record (Southwest Airlines, 2008). In this financial year when most of the airlines companies were operating on losses Southwest Airlines earned a positive net income. All its rivals including AMR Corporation, Delta Airlines and Continental Airlines incurred losses during the same period. These companies failed to earn any positive income even at the operating level as is evident from their negative operating margin. While the quarterly revenue growth of the industry has grown by 13.10% nearly all the major airlines companies witnessed a fall in their revenue during this time. This fall has been lowest for Southwest Airlines at 0.80% whereas AMR Corporation and Continental Airlines reported a fall in their quarterly revenue of nearly 7.40% and 8.3% respectively. The EPS of the industry is negative at $2.19; Southwest Airlines has managed to earn a positive EPS (Yahoo Finance- c, 2010). Recommendation A company must have an ideal mix of debt and equity in its capital base. Any excessive reliance on any particular source is not good for its financial health. High amount of equity dilutes the ownership of the company while high debt levels create financial burdens for the company. Delta Airlines has a similar case as is evident from its debt-equity ratio of 50.50. As a result the interest obligation of the company for 2008 of $705 million is significantly higher than its interest expense of $390 million for the previous year (Delta Airlines Inc, 2008). It is suggested that the company reduce its debt to ideal levels otherwise it can create problems for the company. The operating cost of the company is also very high as is evident from the operating ratio which is more than one at 1.36. It is important that the company exercises control over its operating expenses if it wants to attain profitability. Another crucial area where the company needs to work upon is towards improving its net margins. The investors are attracted to companies that pay a positive return on their investment. To remain attractive to the shareholders it is important that the company manages its costs efficiently so that it can reward its shareholders in the form of higher capital appreciation. Reference Damodaran, A. No Date. Debt: A Balance Sheet Format. Leonard N. Stern School of Business. Available at: http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds/ch7.pdf [Accessed on February 2, 2010]. Delta Airlines Inc. 2008. Consolidated Statement of Operations. Annual Reports. Available at: http://images.delta.com.edgesuite.net/delta/pdfs/annual_reports/2008_10K.pdf [Accessed on February 2, 2010]. Drake, P.P. No Date. Financial ratio analysis. James Madison University. Available at: http://peregrin.jmu.edu/~drakepp/principles/module2/fin_rat.pdf [Accessed on February 2, 2010]. Massachusetts Institute of Technology. No Date. Interest Coverage Ratio. Class #12: “Risk Assessment”Do Financial Statements Capture Risk?. Available at: http://ocw.mit.edu/NR/rdonlyres/Sloan-School-of-Management/15-535Business-Analysis-Using-Financial-StatementsSpring2003/84211AD5-65D7-422E-B318-3A57C08D2516/0/class12.pdf [Accessed on February 2, 2010]. Ross, A.S. Westerfield, R. Jaffe, J. 2004. Corporate Finance. Tata McGraw-Hill. Southwest Airlines, 2008. Entering the Zone. Annual Reports. Available at: http://www.southwest.com/investor_relations/swaar08.pdf [Accessed on February 2, 2010]. Yahoo Finance-a. 2010. Competitor. Delta Air Lines Inc. Available at: http://finance.yahoo.com/q/co?s=DAL [Accessed on February 2, 2010]. Yahoo Finance-b. 2010. Competitor. Southwest Airlines Co. Available at: http://finance.yahoo.com/q/co?s=LUV [Accessed on February 2, 2010]. Yahoo Finance- c. 2010. Competitors. Continental Airlines, Inc. Available at: http://finance.yahoo.com/q/co?s=CAL [Accessed on February 2, 2010]. Washington State University-a. No Date. Current ratio. Session 2: Ratio Analysis Techniques. Available at: http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page38.htm [Accessed on February 2, 2010]. Washington State University-b. No Date. Ratio Analysis. Available at: http://cbdd.wsu.edu/kewlcontent/cdoutput/TOM505/page25.htm [Accessed on February 2, 2010]. Bibliography Higgins, C.R. 2001. Analysis for financial management. Irwin/McGraw-Hill. International Monetary Fund. 2002. World Economic Outlook: September 2002 : Trade and Finance. International Monetary Fund. Khan, A. 2002. 501 Stock Market Tips and Guidelines. iUniverse. Sinclair, J.T. 2004. Global governance: critical concepts in political science. Taylor & Francis. Annexure- - Read More