Case 3-5: Leasing in the Airline Industry

Case 3-5: Leasing in the Airline Industry

A.      Liquidity, Solvency, & Return on investment ratios of American Airlines, Delta Airlines and United Airlines for Year 8.

	AMR (American)	Delta	UAL (United)
Current Ratio (Current Assets/Current Liabilities )	0.86 times	0.73 times	0.51 times
Total debt to equity (Total Debts/Shareholders Equity)	2.33 times	2.48 times	3.56 times
Long-term debt to equity (Long term debt/Shareholders Equity)	1.49 times	1.39 times	2.17 times
Times interest earned (profit before interest and tax/Interest exp.)	6.82 times	9.31 times	4.46 times
Return on assets (Net income/Total Assets)	5.86%	6.78%	4.42%
Return on equity (Net income / Shareholders equity)	19.5%	23.58%	20.16%

Looking at the current Ratio, Airlines industry’s liquidity position is not strong.  American airlines have 0.86 times of current ratio, delta airlines have 0.73 times and united airlines have 0.51 times current ratio. Besides this, there are other things that  company needs to consider for analysis the liquidity position of the company such as off-balance sheet debts, portion of inventory that are moving slow, portion of receivable that could go bad. The Airlines industry is relies heavily on off balance sheet debts such as operating leases which is not included on Current Ratio. Considering all these factors, overall airlines industry and individual company has poor liquidity position.

Airlines industry’s capital structure and solvency ratio seems risky. Both total debts to equity and long term debts to equity ratio are very high. American airlines has 2.33 times of total debt to equity ratio, indicating that for each of $1 of equity financing  another $2.33 of financing is provided by creditors. Similarly, Delta and United airlines have 2.48 and 3.56 times of total debt to equity financing. Further, Airlines industry is relies heavily on long term debts. American airlines has 1.49 times of long term debts to equity indicating that company is financed 1.49 of long term debts for the finance of $1 of equity. Similarly Delta and United airlines has 1.39 and 2.17 of long term debts to equity ratio.

This ratio does not include other off balance sheet debt such as leasing. Lease note shows that airlines industry as a whole is relies heavily on operating leases, which is in fact a debt but not included on balance sheet.  For the analysis purpose some other information such as company’s contingencies and commitment are unknown. Considering all those factors airlines industry is highly leverage and risky industry. 

Looking at individual company’s financial information the profitability of the airlines company is not on good standing position. Even though, they are able to obtain some percentages of retain on shareholders equity and assets, still their performance are considered poor. American airlines return on equity is 19.5% which means for each $1 of investment, company is earnings $0.195. Similarly, Delta and United airlines have 23.58% and 20.16% of return on shareholders’ equity.

B.       Income statement ($ millions)

Operating revenue decreased by 5%

	American Airlines		Delta Airlines		United Airlines
	Year 8	Year 7	Year 8	Year 7	Year 8	Year 7
Operating revenue	18244.75	17274.80	13431.10	12914.30	16682.95	16509.10
Operating expenses	(16656.16)	(16073.54)	(12289.44)	(11912.21)	(15881.96)	(15917.51)
Operating Income	1588.59	1201.26	1141.66	1002.09	800.99	591.59
Other income & adjustments	198	137	141	91	133	551
Interest exp	(372)	(420)	(197)	(216)	(361)	(291)
Income before tax	1414.59	918.26	1085.66	877.09	572.99	851.59
Tax provision	(495.11)	(321.39)	(379.98)	(307)	(200.55)	(298)
Net income	919.5	597	705.7	570	372.44	553.6

Calculation of ratio after reduction on Revenue and operating expeses.

	AMR (American)	Delta	UAL (United)
Current Ratio (Current Assets/Current Liabilities )	0.86 times	0.73 times	0.51 times
Total debt to equity (Total Debts/Shareholders Equity)	2.33 times	2.48 times	3.56 times
Long-term debt to equity (Long term debt/Shareholders Equity)	1.49 times	1.39 times	2.17 times
Times interest earned (profit before interest and tax/Interest exp.)	4.80 times	6.51 times	2.58 times
Return on assets (Net income/Total Assets)	4.12%	4.83%	2%
Return on equity (Net income / Shareholders equity)	13.73%	16.81%	9.15%

Operating revenue decreased by 10%

	American Airlines		Delta Airlines		United Airlines
	Year 8	Year 7	Year 8	Year 7	Year 8	Year 7
Operating revenue	17284.5	16365.6	12724.20	12234.60	15804.90	15640.20
Operating  expenses	(16445.33)	(15870.08)	(12133.88)	(11761.43)	(15680.93)	(15716.03)
Operating Income	839	495.5	590.3	473.2	124	(76)
Other income & adjustments	198	137	141	91	133	551
Interest exp	(372)	(420)	(197)	(216)	(361)	(291)
Income before tax	665	221.5	534.3	348.2	(104)	(184)
Tax provision	(232.75)	(77.53)	(187)	(121.9)	-	-
Net income	432.25	144	346.7	226.3	(104)	(184)

On the hypothetical revenue level, individual company’s Current ratio, Total debt to equity ratio and long term debt to equity ratio remain the same. Time interest earned ratio, return on equity and return on assets go down. American airlines times interest earned ratio was 6.82 after the decrease on revenue the ratio goes down because company still have the same interest expenses but the revenue to cover those expenses go down. Company’s ability to meet interest expense is going down. Further, company is relies heavily on debt and company has to meet interest obligation. If the revenue of the company goes down then company has difficulty on meeting its interest expenses which makes company more risky. Similarly, decrease on revenue significantly impact the return on equity and return on assets of all three company.

C.      Airlines industry has high fixed cost and low variable cost. This means, Cost structure of airlines industry is dominated by fixed cost which result high operating leverage. Further, airlines industry is more volatile industries. Its revenue arises from combination of demand volatility, cost structure, and competitive pricing. Airlines travel is heavily depends on economic performance of the country. Because of all those reason, airlines heavily depend on leasing as a form of financing. They lasses all types of assets- aircraft, airport terminals, maintenance facilities, property and operating office and equipment.

Options of airlines industry for financing:

·         Special purpose entity.

·         Equity fiancé.

·         Retained earnings.

·         Long term debts (notes, bonds)

·         Short term borrowings.

Leasing is more beneficial for the companies than other types of financing because of the following reasons: On leasing contract, lessee just make the minimum lease payment on yearly basis and can take the full advantages of the assets and lessee just has to pay the amount equal to the percentage of assets used by him/her.  Further, leasing is the most convenient means for a buyer to fiancé its assets.

Lease also has disadvantages, leases do not show in the balance sheet which positively impact the income statement and balance sheets but in fact it hide the true financial position of the company. It undertakes liabilities and assets by keeping lease financing off the balance sheet. Operating Leases understate the current liabilities by keeping the current portion of the principal payment off the balance sheet.

D.      Lease note shows that airlines industries are heavily rely on leases specially operating lease. Classification of Lease and its impact is varying from industry to industry. Even thought airlines industry has high operating lease, it is reasonable for them to have such kind of leasing. Cost structure of airlines is different than other industry. They have to depend heavily on fixed assets. It is reasonable for them to lease all those fixed assets because they cannot afford each of them. For exam, airport terminals, aircraft and so on. Therefore I think it is reasonable for them to depend heavily on lease.

E.       On excel document.

F.       Following are the assumptions that are made while reclassifying the operating lease into capital lease.

·         Assets value of the capital lease is equal to the value of leasing liabilities.

·         Interest for the long term lease varies from short term lease depending on the length of the lease term, economic life of the assets and depreciation. We are assuming that interest on both long term lease and short term lease is the same.

For the reliability of the analysis, instead of using the same interest rate for the operating lease and capital lease, trial an error method could be used to determine the interest rate and uses that rate to identify the present value of the lease payment.

G.