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ACCOUNTING AND FINANCEACCOUNTING AND FINANCE
FinanceFinance Manage Manage Capital StructureCapital Structure: “Mix” of Funding : “Mix” of Funding
Sources (Internal, Debt or Equity)Sources (Internal, Debt or Equity) Implications of Choices: Value and GovernanceImplications of Choices: Value and Governance
PURPOSEAccountingAccounting Record and Report Financial ActivitiesRecord and Report Financial Activities Regulatory Compliance and TaxationRegulatory Compliance and Taxation
ACCOUNTING’S FOCUSACCOUNTING’S FOCUS
TAXATIONTAXATION Adjustments that convert Profits into IncomeAdjustments that convert Profits into Income
REGULATIONREGULATION Non-Compliant or Unacceptable PracticesNon-Compliant or Unacceptable Practices
CONSISTENCYCONSISTENCY Needed for Comparative Decision-MakingNeeded for Comparative Decision-Making
TWO PERSPECTIVES
Financial Accounting Prepare Financial Reports for External Prepare Financial Reports for External
Parties (Investors, Creditors and Tax and Parties (Investors, Creditors and Tax and Regulatory Authorities)Regulatory Authorities)
Managerial Accounting Prepare Information for Internal Analysis Prepare Information for Internal Analysis
and Strategic Decision-makingand Strategic Decision-making
FINANCE’S FOCUSFINANCE’S FOCUS
Manage Capital Structure - Manage Capital Structure - Reconcile Sources/Uses of Reconcile Sources/Uses of CashCash
Timing and Amounts (Operating and Capital)Timing and Amounts (Operating and Capital)
Implications of Capital Implications of Capital Structure ChoicesStructure Choices
Stockholder Rights (Equity and Internal) versus Stockholder Rights (Equity and Internal) versus Cash Flow Claims (Debt)Cash Flow Claims (Debt)
Essential Accounting ReportsEssential Accounting Reports
Balance Sheet
Income Statement
Statement Of Cash
Flows
BALANCE SHEETBALANCE SHEET
Reports Financial Condition as of Specified Date (Month/Quarter/Year End)
Reported Amounts may be Historical Cost or Estimates (Which is more Reliable?)
Reports Assets, Liabilities Reports Assets, Liabilities and Equityand Equity Assets: Property Owned by Firm Liabilities: Debts and Financial
Obligations Equity: Stock Investments/Retained
Earnings
ESSENTIAL ACCOUNTING CONCEPTSESSENTIAL ACCOUNTING CONCEPTS
Variation for Business ValuationVariation for Business Valuation Equity = Assets – LiabilitiesEquity = Assets – Liabilities
* Answers Question of “Why is it called a ‘Balance Sheet?’”
THE ACCOUNTING EQUATION
Assets = Liabilities + EquityAssets = Liabilities + Equity**
INCOME STATEMENTINCOME STATEMENT
Reports Firm’s Financial Performance
(1) Revenues, (2) Expenses, (3) Profits and (4) Net Income Information Reported for Prior
Period (Month, Quarter or Year)
Profits are Results of Firm’s Operations Revenues – Expenses = Profit (Loss)
Net Income includes Allowable Adjustments (Tax and Investment Reports)
ACCOUNTING QUANDRIESACCOUNTING QUANDRIES
Which Rule Provides Better Information?Which Rule Provides Better Information?
Should Transactions be Recorded and Should Transactions be Recorded and Reported…Reported…
When Cash is Received or Paid (When Cash is Received or Paid (Cash Cash BasisBasis) or...) or...When Service Performed or Product When Service Performed or Product Delivered (Delivered (Accrual BasisAccrual Basis))
GAAP says, “Report Transactions when GAAP says, “Report Transactions when Primary Purpose accomplished” (Payment Primary Purpose accomplished” (Payment not relevant)not relevant)
Management and Creditors need to know Management and Creditors need to know about Firm’s Cashabout Firm’s Cash
STATEMENT OF CASH FLOWSSTATEMENT OF CASH FLOWS
Reports Sources and Uses of Cash … Categorized by Activity
OPERATINGOPERATING – Cash Used in/Generated – Cash Used in/Generated by Core Businessby Core Business
INVESTINGINVESTING – Cash Used in/Generated – Cash Used in/Generated by Buying/Selling Assetsby Buying/Selling Assets
FINANCINGFINANCING – Cash Used to pay Debts – Cash Used to pay Debts or Dividends/Generated from Debt or or Dividends/Generated from Debt or Equity Equity
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders Southwest Airlines Co.
We have audited the accompanying consolidated balance sheet of Southwest Airlines Co. as of December 31, 2009 and 2008, and the related consolidated statement of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Southwest Airlines Co. at December 31, 2009 and 2008, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Southwest Airlines Co.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated January 29, 2010 expressed an unqualified opinion thereon.
/s/Ernst & Young LLP
Dallas, Texas January 29, 2010
ACCOUNTING ISSUES: AUDITOR’S OPINIONACCOUNTING ISSUES: AUDITOR’S OPINION
(1) Accountants are Certified, not Information and (2) Statements are “Fair Presentation”; Accuracy is Management’s Responsibility
ACCOUNTING ISSUES: SOX CERTIFICATIONACCOUNTING ISSUES: SOX CERTIFICATION
(1) Personal responsibility for Disclosures, (2) Enhanced Internal Controls and (3) More Disclosures
Question: SOX enacted in 2002. Did it keep current financial crisis from being worse? Or did it make things worse?
THREE ESSENTIAL METRICSTHREE ESSENTIAL METRICS
Current RatioCurrent Ratio
Debt-to-Equity RatioDebt-to-Equity Ratio
Return-on-Equity RatioReturn-on-Equity Ratio
FORMULAFORMULA: Current Assets : Current Assets Current Liabilities Current Liabilities
PURPOSEPURPOSE: Assesses whether Firm can meet : Assesses whether Firm can meet Near-term ObligationsNear-term ObligationsNOTE: Analyze Trends - Are changes caused by NOTE: Analyze Trends - Are changes caused by
decreasing cash or increasing liabilities? decreasing cash or increasing liabilities? Should not Should not consistentlyconsistently be less than 1:1 be less than 1:1
** (1) Capacity of Business to pay (1) Capacity of Business to pay Current LiabilitiesCurrent Liabilities
(2) Extent of Effect on Asset’s Value (2) Extent of Effect on Asset’s Value caused by Sale (conversion to cash)caused by Sale (conversion to cash)
†† Current AssetsCurrent Assets: Can or Will be : Can or Will be Converted to Cash within 1 YearConverted to Cash within 1 Year
Current LiabilitiesCurrent Liabilities: Due within 1 : Due within 1 YearYear
THREE ESSENTIAL METRICSTHREE ESSENTIAL METRICS
CURRENT CURRENT RATIORATIO
MeasuresMeasures LIQUIDITY* by Comparing by Comparing CurrentCurrent†† Assets with Assets with CurrentCurrent† Liabilities Liabilities
THREE ESSENTIAL METRICSTHREE ESSENTIAL METRICS
DEBT-TO-EQUITY RATIODEBT-TO-EQUITY RATIOAssesses Firm’s Capital StructureAssesses Firm’s Capital Structure**
((LEVERAGINGLEVERAGING)) FORMULAFORMULA: Long-TermDebt : Long-TermDebt Equity Equity PURPOSE: PURPOSE: Evaluate Debt’s Fixed-cost Evaluate Debt’s Fixed-cost
BurdenBurden
Remember: Debt requires Periodic Cash Payments; Equity does not
** Mix of Sources of Funds used to Mix of Sources of Funds used to Finance Firm’s Capital Costs Finance Firm’s Capital Costs and Operating Expensesand Operating Expenses
THREE ESSENTIAL METRICSTHREE ESSENTIAL METRICS
RETURN-ON-EQUITYRETURN-ON-EQUITYMeasures Rate of Return Earned for ShareholdersMeasures Rate of Return Earned for Shareholders
FORMULA: Net Income FORMULA: Net Income Shareholders’ Shareholders’ EquityEquity
Evaluates Management’s Evaluates Management’s EfficiencyEfficiencyNOTE: Not Return-on-Investment
FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT
RECONCILE SOURCES/ USES OF RECONCILE SOURCES/ USES OF CASHCASH
Operating NeedsOperating Needs:: Timing and Timing and AmountsAmounts
Capital NeedsCapital Needs:: Growth, Growth, Contraction Contraction or or New EnterprisesNew Enterprises
Internal and External ContingenciesInternal and External Contingencies
Strategic Problem: Economically balance Profit-Producing Characteristics of Assets with Implications of Capital Structure Choices
CAPITAL STRUCTURECAPITAL STRUCTURE
FINANCING: FINANCING: INTERNALINTERNAL oror EXTERNALEXTERNAL
Choice depends on Timing, Choice depends on Timing, Available Amounts and Costs to Available Amounts and Costs to Obtain Obtain andand… …
Implications for Implications for OperationsOperations (Debt’s Claims on Cash (Debt’s Claims on Cash Flow/Assets) and Flow/Assets) and GovernanceGovernance (Common Stockholders’ Right to (Common Stockholders’ Right to Vote)Vote)
CAPITAL STRUCTURECAPITAL STRUCTURE
INTERNALLY GENERATED INTERNALLY GENERATED FINANCINGFINANCING
Retained Earnings (No Dividend Retained Earnings (No Dividend Payout)Payout)
Vendor Financing (Accounts Vendor Financing (Accounts Payable) orPayable) or
Sales Terms (Accounts Sales Terms (Accounts Receivable)Receivable)
Advantages:Advantages: No No Application/Approval ProcessApplication/Approval Process
Immediately Immediately AvailableAvailable
No Direct No Direct Governance ImplicationsGovernance Implications
CAPITAL STRUCTURECAPITAL STRUCTURE
EXTERNAL FUNDING: DEBTEXTERNAL FUNDING: DEBTObtained from Commercial Banks, Obtained from Commercial Banks,
Finance Companies and Private Finance Companies and Private PartiesParties
Subject to Creditworthiness/Debt Subject to Creditworthiness/Debt Servicing CapacityServicing Capacity
Negative Covenants: Restrictions on Negative Covenants: Restrictions on Other Borrowings, Profitability, Current Other Borrowings, Profitability, Current Ratio and moreRatio and more
Cash Flow Implications: Repayment Cash Flow Implications: Repayment Terms, Interest Charges, Fees, Reports Terms, Interest Charges, Fees, Reports and more…and more…
CAPITAL STRUCTURECAPITAL STRUCTURE
EXTERNAL FUNDING: EXTERNAL FUNDING: EQUITYEQUITY
Public EquityPublic Equity: Obtained from : Obtained from Investment Banker Investment Banker through Initial through Initial Public Offering (IPO)/Stock Issue or Public Offering (IPO)/Stock Issue or Private EquityPrivate Equity: : Venture CapitalistVenture Capitalist
Sale of Fractional OwnershipSale of Fractional Ownership: Cost is : Cost is tradeoff between Capital received and tradeoff between Capital received and Control Given UpControl Given Up
Control RightsControl Rights: Employment : Employment Agreements, Board Memberships, Agreements, Board Memberships, Decision-Making, Voting Interests…Decision-Making, Voting Interests…
FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT
CAPITAL STRUCTURE: CAPITAL STRUCTURE: IMPLICATIONSIMPLICATIONS
Internal Funds (Retained Earnings)Internal Funds (Retained Earnings) Shareholder Expectations Shareholder Expectations
External Debt (Bonds and Loans)External Debt (Bonds and Loans) Covenants may restrict Growth; Rate RiskCovenants may restrict Growth; Rate Risk
External Equity (Sale of Ownership External Equity (Sale of Ownership Interest)Interest) Voting RightsVoting Rights
# Shares ($10 Par Value*) 100 50 20
$ 850
(800)
$ 50
-----
$ 50
(20)
$ 30
30¢
The “Magic” of LeveragingThe “Magic” of Leveraging
What happens to EPS when What happens to EPS when Capital Structure Changes?Capital Structure Changes?
• 50% Debt = 50% Increase50% Debt = 50% Increase• 80% Debt = EPS 80% Debt = EPS Triples!Triples!
What happens if What happens if (when) Revenues (when) Revenues decrease to $850?decrease to $850?
Does it help to reduce Interest Rate by 25% to 7Does it help to reduce Interest Rate by 25% to 7½½%?%?
Answer: No. Interest Expense decreases to $60 which only reduces Loss to (50¢).
$ 850
(800)
$ 50
(50)
$ 0
------
$ 0
$ 0
$ 850
(800)
$ 50
(80)
$ (30)
-----
$ (30)
$ (1.50)
* “Par Value” is a Nominal, Minimum Value assigned to a Company’s stock upon its incorporation
““Howard, Think about your Capital Structure…”Howard, Think about your Capital Structure…”
SouthwestSouthwest’s ’s
Business Business PlanPlan
June 18, 1971: Began Service June 18, 1971: Began Service (Organized 1967)(Organized 1967)
May 2003: Largest Domestic Carrier May 2003: Largest Domestic Carrier
More than 3,400 Daily Flights – 64% More than 3,400 Daily Flights – 64% Market ShareMarket Share
Flies only Boeing 737 Jets: 537 Planes Flies only Boeing 737 Jets: 537 Planes in Fleet. Each flies about 12 hours in Fleet. Each flies about 12 hours daily (6.25 Trips)daily (6.25 Trips)
83% Unionized (73% at General 83% Unionized (73% at General MotorsMotors))
101.4 Million Passengers flew on 101.4 Million Passengers flew on Southwest – Ticket Sold every 2.7 Southwest – Ticket Sold every 2.7 secondsseconds20092009: Received 90,043 Resumes - : Received 90,043 Resumes - Hired 831 “Southwest Warriors” Hired 831 “Southwest Warriors” (1:108)(1:108)Consumed 1.4 Billion Gallons of Consumed 1.4 Billion Gallons of Jet Fuel - Average price: Jet Fuel - Average price: $1.97/Gallon$1.97/GallonServed 63.2 Million Cans of Served 63.2 Million Cans of Soda/Water, 14.3 Million “Adult Soda/Water, 14.3 Million “Adult Beverages”Beverages”and 90 Million Bags of Peanutsand 90 Million Bags of Peanuts
Name Two things Southwest has Name Two things Southwest has NEVERNEVER done?done?
Answer: Answer: (1) Lost Money - Profitable for 37 (1) Lost Money - Profitable for 37 Consecutive Years and (2) Laid Anyone Off Consecutive Years and (2) Laid Anyone Off
Does Capital Structure Matter?Does Capital Structure Matter?
Long-Term Debt to Stockholders’ (Book) Equity
Delta $63.90 to 1
Continental
$ 8.97 to 1
Jet Blue $ 1.90 to 1
Southwest
$ 0.61 to 1
Net Income (Loss)Millions
( $1,237)
( $282)
$ 58$ 58
$ 99$ 99
Let’s “dive into” some of Southwest’s Numbers…Let’s “dive into” some of Southwest’s Numbers…
Fuel Costs: 18% Lower Fuel Costs ($669M )
Full-Time Employees: 780 fewer Employees, but Salaries and Wages were 3.8% higher
Revenues: 96% from Passenger Ticket Sales
Salaries: 34.4% (2009) versus 31.6% (2008)
Taxes: 39.6% Effective Rate
Valuation Analysis
Stock Price (April 14, 2010) $ 13.40
Market Value(742.8 M Shares*) $ 9,953 M
Book Value(Total Stockholders’ Equity $ 5,466 M
Market Value/Book Value 182%
Earnings per Share ($99/742M) $ 0.13
Stock Price Multiple ($13.40/$0.13) 103.1 X
Net Income from Income Statement: $99 MillionNet Income from Income Statement: $99 Million
Comparative Ratio Analysis
2009 2008
Current Ratio 1.25:1 0.95:1
Debt-to-Equity 0.61:1 0.71:1
Return-on-Equity 1.8% 2.6%
*Shares Outstanding (742.8 M) = Number Issued (807.6 M) less Number held in Treasury (64.8 M)*Shares Outstanding (742.8 M) = Number Issued (807.6 M) less Number held in Treasury (64.8 M)
Note Reconciliation of Note Reconciliation of Beginning/End-of-Period Cash Beginning/End-of-Period Cash with Cash on Balance Sheet with Cash on Balance Sheet
2009 Operations generated 2009 Operations generated Surplus Cash ($985M) used to Surplus Cash ($985M) used to Purchase Aircraft ($585M) and Purchase Aircraft ($585M) and Pay Revolving Credit Facility Pay Revolving Credit Facility ($400M)($400M)
Note : 2008 Operations did not Note : 2008 Operations did not produce sufficient Cash ($1.5 B produce sufficient Cash ($1.5 B Shortfall). Shortfall).
2010 plans call for purchasing 2010 plans call for purchasing 10 aircraft; 13 purchased in 2009 10 aircraft; 13 purchased in 2009 and 28 purchased in 2008and 28 purchased in 2008
Why Didn’t Anyone See This Why Didn’t Anyone See This Coming?Coming?Stock PriceStock Price
January 3, 2000January 3, 2000 $ 43.44$ 43.44
August 17 and 23, 2000August 17 and 23, 2000 90.0090.00
December 29, 2000December 29, 2000 83.1383.13
October 29, 2001October 29, 2001 13.8113.81
November 30, 2001November 30, 2001 26¢26¢
Significant EventsSignificant Events
Aug 2001Aug 2001 CEO Jeff Skilling Resigns (October CEO Jeff Skilling Resigns (October 2006 – Sentenced to 24 Years)2006 – Sentenced to 24 Years)
Nov 2001Nov 2001 Last 4 Years’ Earnings RestatedLast 4 Years’ Earnings RestatedBond Rating lowered to “Junk”Bond Rating lowered to “Junk”
Dec 2, 2001Dec 2, 2001 Files Chapter 11 (Reorganization) Files Chapter 11 (Reorganization) Bankruptcy PetitionBankruptcy Petition
Jan 1, 2004Jan 1, 2004 Bankruptcy converted to Chapter 7 Bankruptcy converted to Chapter 7 (Liquidation)(Liquidation)
Would Would studying studying Enron’s Enron’s
Statement of Statement of Cash Flows Cash Flows and a Little and a Little Common Common
Sense have Sense have saved saved
Billions?Billions?Note 9. Supplemental Note 9. Supplemental Cash Flow Cash Flow InformationInformation
Cash Payments for Income Taxes Cash Payments for Income Taxes 2000: $62 (4.4%*) 2000: $62 (4.4%*) [Federal Rate: 35%; *Effective Rate] [Federal Rate: 35%; *Effective Rate] 1999: $51 (5.1%*)1999: $51 (5.1%*)
1998: $73 (8.3%*)1998: $73 (8.3%*)
Note 16. Related Note 16. Related Party TransactionsParty Transactions
““In 2000 and 1999, Enron entered into transactions with limited partnerships * * * whose general In 2000 and 1999, Enron entered into transactions with limited partnerships * * * whose general partners’ managing member is a senior officer of Enron * * *[.] Management believes the terms of the partners’ managing member is a senior officer of Enron * * *[.] Management believes the terms of the transactions * * * were reasonable compared to those which could have been negotiated with unrelated transactions * * * were reasonable compared to those which could have been negotiated with unrelated third parties.”third parties.”
Nota BeneNota Bene Contrast 1998 and 1999 Cash Sources (Operations: 1/3 and Financing: 2/3) with 2000 Cash SourcesContrast 1998 and 1999 Cash Sources (Operations: 1/3 and Financing: 2/3) with 2000 Cash Sources