# Southwest Airline Ratio Analysis

Southwest Airline Ratio Analysis

Southwest Airlines Financial Ratio Analysis

Since its beginnings as a scheduled airline in 1971, Southwest Airlines has distinguished itself within the US airline industry as a unique player. Its commitment to offering a low fare structure to both businesses and leisure travelers has made air travel more affordable to many consumers and has caused a consistent increase in demand for expansion into new markets, as well as increasing price competition within the cities it serves. Since the airline regulation in 1978, Southwest has dramatically increased the number of markets it serves and its market share. It has also been the model for a number of less successful low cost start-up airlines, such as ValuJet and People’s Express.

Various ratios are used by managers and investors to analyze and forecast the profitability and efficiency of a company. This paper will discuss the ratios used for the financial analysis of Southwest Airlines.

Short Term Liquidity Ratios for Southwest Airlines Co.

This ratio is used to measure the solvency, or the ability, of Southwest Airlines Co. to meet its short-term financial obligations and to assess the liquidity, or the ability, of Southwest Airlines Co. to convert current assets to cash to reduce current liabilities. The most widely used financial ratios for establishing the short-term liquidity of a company are current ratio and quick ratio. Southwest’s current ratio is 1.01 and its quick ratio is 0.86.

The short-term liquidity ratios are used in the evaluation of short-term liquidity to convert current assets into cash in order to reduce the financial obligations of the company as they become due. These ratios are particularly significant to the creditors and potential lenders of a company because they determine the ability of that company to meet current payments of a debt. However, investors and stockholders are also interested in the company’s definition of current assets and current liabilities since these classifications have a direct impact on the amount of available working capital of an entity. As a general

rule of thumb, a current ratio of 2:1 and a quick ratio of 1:1 are considered to be acceptable. Other ratios commonly used to evaluate short-term liquidity are average collection period in days and inventory turnover. The main focus of these ratios is to evaluate how soon accounts receivable will be collected and how soon inventory will be sold.

Long Term Solvency Ratios for Southwest Airlines Co.

The most commonly used ratios by financial analysts for determining the long- term solvency of an entities are Debt-to-Total Assists, Debt-to-Equity, and Long-Term-Debt-to-Total-Capital. These ratios are used for solvency evaluation. The main focus of these ratios is the entity’s ability to repay long-term creditors. Both creditors and shareholders are equally interested in these ratios. Based on an analysis of the debt-to-equity ratio, Southwest’s debt-to-equity ratio in 2003 was its lowest in the past five years, at 0.22. America West’s ratio was almost double that of Southwest, while the ratio for American airlines was at 0.76, almost three times the value of Southwest’s ratio. Typically, these ratios should be as low as possible. These ratios indicate the entity’s ability to withstand relatively sour business conditions without suffering net losses or insolvency. Although, these ratios should not be taken at face value since they are dependent on many factors, these ratios are most useful for making apple-to-apple comparisons in the industry. This shows the increasing stability of Southwest Airlines and the improving ability of the entity to meet its long-term obligations successfully without being in danger of encountering net losses or insolvency.

Profitability ratios are used in an effort to evaluate management’s ability to monitor and control expenses and to earn a profit on resources committed to the business. The ratios assess Southwest Airlines’ strengths and weaknesses, operating results and growth potential. These ratios are used to measure how efficiently the assets are being used to generate net income and sales. The higher the ratio, the more effectively a company is using their assets. The ratios also allow comparison of the profitability of Southwest Airlines to that of similar airlines within the industry. The main focus of these

ratios are the entity’s ability to repay long-term creditors. Both creditors and shareholders are equally interested in these ratios. The seven primary ratios used to determine profitability are Gross-Profit, Gross Profit Percentage, Return on Sales, Return on Stockholder’s Equity, Asset Turnover, Pretax return on Operating Assets and Earning Per Share.

Gross profit and gross profit percentage are used to assess whether the profits will cover operating expenses. The gross profit rate for Southwest is 1.90 and has remained steady in the periods since 2000. Southwest Airlines has a relatively high gross profit rate, primarily because of low operating costs. Low operating costs is one of Southwest Airlines’ claims to fame, as discussed in their 2003 Annual Report, “By keeping costs low, we keep our fares low. This, in turn, gives customers the freedom to fly.”

Return on sales discloses the profits earned and measures the efficiency of the company. The return on sales is above the industry average of 2.9%. Such a favorable comparison has proven to be the trend for Southwest Airlines.

Return on stockholder’s equity assesses the effective use of resources provided by stockholders. Southwest’s return on equity is 6.57. This measure of performance is one of the key profitability ratios. Although the return on equity has been below the industry median, Southwest Airlines has had a significant increase since 2000.

The higher the ratio for asset turnover, the more effective the company is using its assets to produce sales. It appears that Southwest is reasonably using their assets. They do not have excess turnover, which would signal the company is strapped for cash and their turnover is not too low which would mean they have a shortage of cash and other assets. It appears that Southwest has remained relatively stable over the past five years. When comparing Southwest to the industry, they are equal or just slightly above the industry average in asset turnover.

Like Asset Turnover, the higher the number of the Pretax Return on Operating Income, the better the company is doing using their assets to produce operating income. The most popular profitability ratio is Earnings Per Share (EPS). This is one of the easier ratios to use when comparing companies because many firms include this ratio on their Income Statement. Earning per share gives a picture of the current net income in a particular period to the number of outstanding shares of stock. Southwest’s earnings per share have steadily increased over the past five years. Southwest’s earning per share is 0.38 which appears to be around the industry median. Two factors contributes to high earnings per share, they are operating income and operating expenses. Southwest’s operating income and operating expenses for 2004 are 6,530 and 5976 respectively. One expense that can affect net income and consequently earnings per share are the cost of jet fuel. Jet fuel accounts for 15 percent of Southwest’s expenses. The cost of jet fuel is volatile and depends on many outside factors. Fuel and oil expenses per available seat mile decreased 6.7 percent in 2003. Southwest believes they will benefit from lower fuel costs into the first quarter of 2004. Research analysts estimate that Southwest earnings per share will increase signifantly over the next year.

The most commonly used ratios in determining the return on investment are price-earnings, dividend-yield and dividend-payout. Price-Earnings Ratio measures how confident the public is in the ability of the company to increase their revenue. Southwest Airlines has a ratio of 39.23, which is comparable to the industry average, indicating that the public feels that the net income of the company will grow at a fast pace. Dividend Yield measures the returns on stock purchased. The dividend-yield (0.13), for Southwest Airlines is extremely low, indicating that the company is most likely reinvesting their profit in the future expansion of the company. Investors who wish to receive large cash return on their investment each year would not invest in Southwest Airlines. Dividend-Payout measures the percentage a company pays out to its investors in dividends. As we can see, Southwest Airlines has an extremely low dividend-payout ratio; Southwest’s dividend payout ratio is 5%, once again indicating that most of their profit is being reinvested into the growth of the company.

In evaluating the income statement and balance sheet of Southwest Airlines, there should be attentiveness to the Current Ratio, Total Assets Turnover, and Return on Stockholders Equity. Since the cost of an aircraft and fuel are much more expensive than that of a widget manufacturer, it would seem wise to keep operating costs in check. The Current Ratio will give an indication of the funds available to venture into new markets. Southwest Airlines operates to bring the lowest cost to consumers, this is made possible with attention to assets. The Total Assets turnover will tell Southwest Airlines and its investors if they are generating a sufficient amount of business for the size of its assets.

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