Week 8

Financial Analysis and Proposal Component 3

Hardy & Matson (2004) argue that the management of a company must continually evaluate the financial status of their firm to evaluate whether the firm will be able to meet is future obligations. Managers must always ensure a balance between their firm’s operations, marketing and financial status. A deficit in any of the three departments leads to an imbalance, which is detrimental to the firm. The aim of this article is to analyze and compare the future financial health of the Southwest Airlines and JetBlue Airlines based on the 9-step assessment process.

The assignment will however focus on step 5: External Financing Need, Step 6: Target Sources of Finance and Step 7: Viability of 3-5 Years Plan. Striking a balance is important in ensuring long-term success, which is in line with the firm’s long-term goals, and strategies .Investors and other stakeholders look at the long-term health of an enterprise when making their decisions such as extending credit to the company, long-term supplier arrangements or investing in the enterprise’s equity. Some companies have in the past initiated very ambitious programs only to later discover they cannot finance such programs. The companies had to abandon the programs, which resulted in waste of resources (Hardy & Matson, 2004).

Step 5 -future external financing needs

The need for external financing in a company depends on the company’s future sales growth, future profitability, profit retention, and its cash cycle. Companies with a long cash cycle, low profitability, and low retention are particularly strong candidates for external long term financing (Hardy & Matson, 2004). Southwest Airlines has a strong ability to generate cash flows consistently. This has helped the company reduce its debt significantly over the last few years. In the 2015 financial year, the company generated $3.2 billion cash flow from operations and another $1.1 billion in free cash flows. The company ended the year with $3.1 billion in cash in its financial statement. However, this is set to change as the company plans to embark on a rapid expansion program, which includes expanding its capacity of its US routes, as well as commence international flights. This means the company will have to build a new international terminal, acquire new airplanes, hire more staff, as well as invest in parking spots in its new routes. This also means the company total assets will grow significantly in the next 3-5 years. Though the company might be able to finance its activities out of its operating income, in the near future it may be forced to seek long-term debts to acquire new aircrafts to use in the international routes. Currently, the company is constructing a $156 million, 5-gate concourse in Houston and another in Fort Lauderdale terminal at a cost of $295 million (Jeff, 2015). Overall, the company will need close to $ 2 billion to finance its international expansion program over the next 3-5 years.

JetBlue Airlines on the other hand is looking to increase its revenue and margins by increasing capacity in its existing aircrafts and leveraging on its existing products. The new initiatives are estimated to contribute $450 million annually in the next 3-5 years. Addition of extra seats estimated to generate an incremental $100 million in the 2017 financial year. The company’s operating margin grew by 10.7 in 2015. However, the company has had to delay its plan to deliver 18 Airbus narrow bodies, which should have commenced in 2016 through to 2023. This has helped the company reduce capital expenditure by $900 million through 2017. Due to the deferral, the company is targeting to offer a return on invested capital of 10% or more in 2017, which is a steady growth from a low of 5.3% in 2014. As such, JetBlue Airlines does not have a huge need for external financing as it can finance the expansion through its operating income (Mary, 2016). Step 6 - Target Sources of Finance

Southwest Airlines has a low debt-equity ratio of 1.6. This means that Southwest Airlines can readily access long-term debt. The company has a good reputation in paying its suppliers. In fact, over the last few years the company has been reducing its proportion of debt financing buoyed by its good performance. Southwest airlines made $561 million debt repayments in 2014 and $184 million in 2015. The company has debt repayment of $300 million annually. I think the company can add around 450 million annual debt repayments without compromising its debt-equity policy. As such, the company can borrow in excess of $1 billion repayable in 25 years to finance its expansion in addition to using retained income. In addition to seeking low priced long-term debts stretching over 20 years, the airline can also enter into a leasing agreement with aircraft manufacturers rather than purchasing the aircrafts. Having made lease payments of $50 million in 2015, I think the company can add around $20 million annually in lease payments, which would be financed by increased revenues from international flights (Jeff, 2015).

On the other hand, JetBlue Airlines made debt and lease repayments of $216 million in 2015. After deferring acquisition of new aircrafts, the company is not under any pressure to take up additional long-term financing. In fact, the company seeks to take advantage of decline in fuel prices to make opportunistic debt prepayments. The company had projected a capital expenditure of $820 million to $870 million for 2015 (Karen, 2013). Due to the deferral, the capital expenditure is set to remain more or less the same for the next few years, which mean the company can finance its expansion program, and still manage to pay maturing debts out of its operating income. As such, there is no need to take up more debt from external sources.

Step 7 – Viability of the Three to Five Year Plan

Step seven of assessing an enterprise’s future financial health involves assessing whether the enterprises debt-equity mix is in line with the enterprises debt policy (Hardy & Matson, 2004). Southwest Airlines has one of the low debt-equity ratios of 1.6 in the aviation industry. As such, adding more debt to finance its international expansion strategies will still be in line with its debt policy. As such, the company can see of its capital expenditure projects without worrying about its debt-equity mix getting out of proportion (Jeff, 2015).

JetBlue’s aircraft deferral will help the company meet its goals. However, without the deferrals, the company would have found it hard to meet all its goals due to lack of enough finances forcing it to look for external financing. With the deferrals, the company will generate positive cash flows after posting negative cash flows in 2014 and barely managing positive cash flows in 2015 (Karen, 2013). With the deferral, the new investments, product strategy, and strategic goals are in line with the company’s financing capability and its debt-equity policy. However, had the company followed through with the acquisition of the 18 aircrafts, the company would have been forced to increase its debt ratio to finance all its projects. This would have put the company’s debt-equity mix out of line with its debt policy JetBlue’s non-aircraft expenditure should fall to around $150 million in 2016. In addition, the company would have found it hard repaying its additional debt given the fact that it expects its current debt maturities to increase in the next five years with 2016 set to post a high of $455 million. The company decided to work on reducing its level of encumbered assets to provide flexibility in managing its capital requirements and cost of debt. In 2015, long-term debt and capital leases weighted average interest rate stood at 4.6%. Due to their low debts, the two companies can weather any unsteady passenger volumes and increase in fuel prices in the next 3-5 years, as they will not have to struggle to borrow externally to pay maturing debts (Mary, 2016).

References

Hardy, M., & Matson, B. (2004). Data driven investing. Newbury Port, Mass: Data Driven Pub.

Jeff, T. (2015, June 11). How Southwest's FP&A Team Helps The Airline's Strategy Take Off.