LONG-TERM SOLVENCY RISK: SOUTHWEST AND LUFTHANSA AIRLINES
The first decade of the 21st century witnessed a flurry of losses, bankruptcies, acquisitions, and strategic partnerships in the airline industry. The heavily levered firms in the industry are particularly susceptible to increases in fuel prices, economic changes that affect travel, and safety concerns. These conditions require the analyst to have a strong understanding of the long-term solvency risk of firms in the airline industry.
Two of the larger liabilities of airlines relate to promises to provide free flights to cus- tomers (frequent-flyer programs) and promises to make cash payments under flight equip- ment and ground facilities agreements. The former liability is captured in the total liabilities to assets ratio. The latter promise is captured in the total liabilities to assets ratio and in the long-term debt to shareholders' equity ratio, but only if the promises are treated as long-term debt.
Exhibits 6.22-6.27 (see pages 514-521) present the income statements, balance sheets, and other key information for U.S. airline Southwest, which prepares financial statements under U.S. GAAP, and German airline Lufthansa, which prepares financial statements under IFRS.
Required
a. Using the information in the exhibits, provide a comprehensive and detailed comparison of the long-term solvency risk of Southwest to Lufthansa as of December 31, 2008, and as of December 31, 2007. (Ignore tax effects. Deferred taxes are covered in Chapter 8 on operating activities.)
(1) Consider the following ratios in your analysis: Liabilities to assets ratio = Total Liabilities/Total Assets
Long-term debt to shareholders' equity ratio = Long-Term Debt/ Total Shareholders' Equity
Operating cash flow to average total liabilities ratio = Operating Cash Flow/ Average Total Liabilities
Interest coverage ratio (cash basis) = (Operating Cash Flow + Interest Paid + Taxes Paid)/Interest Paid
(2) Compute the ratios using financial information (a) as reported and (b) after capitalization of operating leases. (Hint: Adjusting operating cash flow for assumed lease capitalization requires the removal of rent paid from operating cash flows and the inclusion of interest paid in operating cash flows. Use rent expense and interest expense to approximate rent paid and interest paid, respectively.
b. An analyst who compares the debt ratios of firms under U.S. GAAP and IFRS must consider key differences in the two sets of standards related to convertible debt and troubled debt restructurings. In general, which system would most likely yield lower debt and higher equity? Explain.
Text Book: Financial Reporting, Financial Statement Analysis and Valuation: A Strategic Perspective By James Wahlen, Stephen Baginski, Mark Bradshaw.