Southwest Airlines, Case Study Example

Introduction

The aviation industry is arguably one of the most important industries in the economic growth and development of any given economy, especially the United States. Aviation is a critical component of the transportation industry and network, which is essential for national, regional, and global business. Airlines play a vital role in the creation of jobs, facilitation of tourism and trade, and generating economic growth. As such, the evaluation of the performance of airlines plays an integral role in assessing and projecting trends in the industry and their potential impact on other industries.

Internal Environment Analysis

Comprehensive Examination of Financial Situation

A vital component of the internal environment of a business is its financial situation. The financial situation of a company inherently determines the scope of the financial and marketing resources it can employ to achieve its business goals and objectives. To better understand Southwest’s ability to cope with the evolving external environment, an assessment of its financial situation is required. Four elements of financial performance provide a good idea of the financial situation of an airline, i.e., profitability, liquidity, leverage, and activity. This analysis considers these four areas of financial performance by considering a single financial ratio in each category.

Profitability

While there are numerous measures of financial performance, profitability is arguably the most significant from an investor’s point of view. Profitability of a business venture is essentially its ability to generate financial gain or profit using the resources at its disposal (Lasher, 2017). The profitability of a business venture affects numerous aspects of its current and future growth and development. Vital financial resources for growth and expansion through financing from banks and investors, are readily available to businesses that generate significant profitability (Keown et al., 2020). As such, Southwest Airlines profitability relative to its competitors influences its ability to attract investors and gain access to different sources of financing.  While there are several measures of profitability, the return on assets (ROA) and return on equity (ROE) are commonly employed as reliable measures of profitability, especially for airlines (Lev & Gu, 2016).

Return on Assets (ROA)

The ROA is a profitability measure that considers the profits (or losses) after taxes plus any interest payment and compares the value o the value of the total assets owned and controlled by the business (Lasher, 2017). As such, it measures Southwest’s ability to utilize its assets, such as airplanes and other equipment, to generate profit, and it is calculated using the Equation 1 (Appendix 4).

Before the COVID-19 pandemic, Southwest depicts a general growth trend in its ROA in the past 10 years growing from 2.17 in 2011 to 8.82 in 2019. Southwest experienced year-on-year growth in its ROA between 2011 and 2017, when it reached a peak of 14.41 in 2017, which indicated that the airline generated $14.41 in profits for every dollar in assets. The COVID-19 pandemic dealt a major blow to its ROA reporting a negative value of (-$ 10.14) in 2020. This indicated that for every dollar of assets, the company reported $10.14 in losses.

When compared to its closest competitor, United, Southwest depicts a steady performance that is characterized by consistency. Additionally, Southwest consistently outperforms United in terms of generating profits from its assets in the past 10 years except for 2015, when Southwest reported an ROA of 10.51 compared to United’s 18.77. This indicates that except for 2015, Southwest generates more profit from its assets compared to its closest rival, United. This performance is consistent during the COVID-19 pandemic as United reported an ROA of -17.57 compared to Southwest’s -10.14, showing United generating $7.43 more in losses for every dollar of assets.

Return on Equity (ROE)

The ROE is another measure of profitability that evaluates a firms ability to employ its stockholder’s equity to generate profits. While the ROA provides information that mostly valuable to management, the ROE provides profitability insight that is mostly valuable to investors (Lasher, 2017). The ROE is obtained using Equation 2 (Appendix 4).

Southwest’s ROE portrays a general growth trend in the past decade, growing from 2.71 in 2011 to 23.27 in 2019. This finding indicates that the company improved its ability to generate profit from its shareholders’ equity by 758% from 2011 to 2019. In 2017, Southwest reported its peak ROE at 36.97, which indicated $36.97 in generated profits for every dollar of shareholders’ equity. However, the COVID-19 pandemic had a tremendous negative effect on the company’s ROE, declining to -32.77 in 2020, which indicated $32.77 in losses for every dollar of shareholders’ equity (Appendix 4). However, it is important to note that the company has been experiencing a downward trend in its ROE before the COVID-19 pandemic, reporting a year-on-year decline between 2017 (36.97) and 2019 (23.37) (Appendix 4).

Southwest’s closest competitor, United, depicted a more erratic ROE, which was characterized by intermittent decline and growth in the past 10 years. As a result, United’s ROE depicts a general decline trend, dropping from 47.55 in 2011 to 27.96 in 2019. Similar to Southwest, United was adversely affected by the COVID-19 pandemic, reporting an ROE of -80.16, which indicates $80.16 in losses for every dollar in shareholders’ equity. As such, United reported a more adverse impact of the COVID-19 pandemic on its ability to employ its shareholders’ equity to generate profits.

Liquidity

While profitability represents fundamental measures of business operations, liquidity is a vital measure of a form’s ability to convert assets into cash while mitigating the loss in value against prevailing market prices. Liability is an integral measure for different types of stakeholders, such as shareholders and creditors (Keown et al., 2020). It is a measure that indicates a firm’s ability to pay off short-term debts and liabilities attributed to its operations. While several measures of liquidity can be used to assess a firm, the current ratio is commonly used for most businesses, including airlines.

Current Ratio

The current ratio is a useful measure of liquidity that evaluates a company’s ability to use its assets that can be quickly turned to cash, i.e., current assets, to meet its short-term debt obligations, i.e., current liabilities and current debts (Lev & Gu, 2016). Equation 3 was used to obtain the current ratio for Southwest Airlines and its closest competitor, United Airlines (Appendix4).

Figure 3: Current Ratio (Southwest vs. United)

Before the COVID-19 pandemic, Southwest’s current ratio portrayed a general decline trend dropping from 0.96 in 2011 to 0.67 in 2019. This trend is indicative of Southwest’s declining ability to settle its current debt obligations using its current assets. In 2011, the company could settle 96% of its current debt obligations using its current assets, which reduced to 67% in 2019. However, due to the COVID-19 pandemic, the company’s current ratio rose to 2.02%, representing a 201% increase in its ability to settle its current debt obligations. This drastic increase in Southwest’s current ratio can be attributed to fewer operations which led to lower current liabilities and debts.

Compared to United, Southwest consistently outperforms its closest competitor except for 2015. United depicts a similar consistent decline trend in its current ratio as Southwest, dropping from 0.97 in 2011 to 0.55 in 2019. The difference is United’s decline is characterized by year-on-year decline during this period. The COVID-19 pandemic did not affect Southwest’s dominant current ratio (2.02) compared to United (1.16).

Leverage

Apart from profitability and liquidity, financial leverage is another integral financial ratio. It is a measure that evaluates the equity attributed to a firm’s shareholders to the financial debt associated with the firm’s operations (Lasher, 2017). Financial leverage is a vital indicator of a firm’s financial policy. Financial leverage is an indicator of the different sources of debt that can boost its earnings.. The analysis employs the debt-to-equity ratio to evaluate the financial leverage of Southwest Airlines and its competitor, United Airlines.

Debt-to-Equity Ratio

A vital measure of financial leverage is the debt-to-equity ratio, which compares the value of a company’s debt to the value of its shareholders’ equity (Lev & Gu, 2016). Equation 4 was used to obtain the debt-to-equity ratio of Southwest Airlines and United (Appendix 4).

Before the COVID-19 pandemic, Southwest depicts a general decline trend in its debt-to-equity ratio dropping from 0.55 in 2011 to 0.27 in 3019. As such, as of 2011, more than half (55%) of the firm’s operations were financed using debt, which declined to 27% in 2019. This downward trend is indicative of the firms decreasing reliance on debt to finance its operations and an increasing reliance on shareholder’s equity. However, the COVID-19 pandemic has led to an increasing reliance on debt to finance its operations as evidenced by a debt-to-equity ratio of 1.16 (Appendix 4). This statistic shows that more than 100% (116%) of Southwest’s operations are currently financed using debt.

Compared to its closest competitor, United, Southwest portrays a lower reliance on debt. United consistently reports a higher debt-to-equity ratio compared to Southwest in the past 10 years. The firm reports an erratic debt-to-equity ratio, which reached its peak in 2012 (27.37), when more than 2,000% of its operations was financed using debt. The COVID-19 pandemic led to United relying more on debt (4.56), where 456% of its operations were financed using debt compared to Southwest (1.16).

Activity

While the profitability, liquidity, and leverage are vital measures of financial performance, activity ratios provide an evaluation of the efficiency of a business in using its resources, mainly assets, liability, and capital, in revenue generation. This analysis employed the asset turnover ratio to evaluate Southwest and United’s activity.

Asset Turnover

The asset turnover ratio is an integral activity ratio that measures the efficiency of a firm in using all its assets to generate revenue (Keown et al., 2020). Equation 5 was employed to obtain the total asset turnover ratios for Southwest Airlines and United Airlines (Appendix 4).

Southwest’s asset turnover ratio depicts a gradual decline in the past 10 years, dropping from 0.93 in 2011 to 0.86 in 2019. This trend indicates a decline in Southwest’s ability to use the assets at its disposal to generate revenue. Southwest generated $0.93 in revenue for every dollar total in assets in 2011, which declined to $0.86 in 2019. However, the COVID-19 pandemic led to a further decline to 0.3, where the company could generate $3.00 for every dollar in total assets.

When compared to its closest rival, United, Southwest consistently shows a lower asset turnover ratio in the past 10 years except for 2016 and 2020. United Airlines slightly outperforms Southwest airlines in generating revenue using the assets at its disposal. However, the COVID-19 pandemic has reduced United’s ability to generate revenue using assets more than Southwest.