Airline Finance: Funding Sources and Financial Statements
Airline Finance
Sources of Funds
Internal Sources:
- Net Earnings
- Depreciation
- Deferred Taxes
External Sources:
- Debt Financing
- Equity Financing
- Leasing
- Vendor Financing
- Venture Capital
Net Earnings
The best and most desired source of funds is net earnings.
- Net earnings = Gross revenues – (taxes + interest + depreciation + other expenses)
If it is a publicly traded company with floating stocks in the capital market, then the company’s board of directors decides how much of the earnings should go to owners (stockholders) in the form of dividends.
Deferred Taxes
Short-term financing source:
- Deferred taxes refer to certain taxes that companies are required to collect for various taxing authorities.
- Federal excise tax
- State sales tax
- Payroll withholding of employee income tax.
Depreciation
Airline’s largest single source of internal funds.
- Depreciation is the allocation of an asset’s cost over its estimated useful life.
- It is a non-cash expense.
- It only works as a financial source as long as the company posts a profit.
Debt Financing
Debt financing refers to the borrowing of funds from financial institutions.
- Long-term commercial loans (beyond a year for fleet and equipment needs)
- Short-term commercial loans (up to 12 months for seasonal needs)
- Line of credit and credit rating play a major role in debt financing.
- Credit rating agencies: S&P, Moody’s, Fitch
- Good credit rating decreases the Basis Points (bps), which is the interest rate on top of the LIBOR.
- LIBOR: London Inter-Bank Offered Borrowing Rate.
Commercial loans can be obtained from:
- Commercial banks
- Financial and life insurance companies
- Mutual funds management groups
- Investment banks
Commercial Banks
Commercial banks require collateral when they lend to airlines because of the market and company volatility.
- Collateral value refers to the value of assets pledged in the event of default.
- Cash flow is the indicator of loan payments, whereas collateral guarantees the repayment of the loan.
- Equipment trust financing: A bank or a group of banks lends the required money for purchasing new equipment, but the title remains with the bank.
- Equipment trust financing increases the security of the loan.
- It is a common method for big fleet planning investments.
Life Insurance, Mutual Funds, and Other Financial Companies
Life insurance is a long-term investment by an individual.
- It can only be cashed after the individual’s death.
- This provides an opportunity for insurance companies to invest in long-term assets such as airplanes.
- One of the world’s biggest leasing companies, ILFC, is owned by the AIG insurance group, the biggest life insurance provider in the world.
Investment Banks
The major task for an investment bank is assisting in raising capital for individuals, corporations, and governments.
- The banks may serve as intermediaries between investment outlets and the aviation industry.
- They are advisors in the development of various types of transactions, such as mergers and the placement of private loans.
Investment bankers provide debt placement and public equity offerings.
- A private debt placement is similar to a bank loan, except the funding source is a private party, such as investor groups or insurance companies.
- Investment banks typically look for a long-term investment.
- Examples of investment banks: Morgan Stanley and Goldman Sachs.
Equity Financing
Equity financing refers to the sale of stocks, bonds, and other equity in the company to the public.
- Equity financing is available almost exclusively to financially strong air carriers.
- Dividend income refers to the distribution of earnings to stockholders of a corporation.
- Capital appreciation refers to the value of capital stock.
Types of Equity Ownership in a Company
Common Stock
- An equity security that represents ownership in a corporation.
- Investors who purchase common stock have voting rights at the company’s annual stockholders’ meeting.
- Common stockholders are not guaranteed dividends, but they expect to receive higher dividends during the company’s prosperous periods.
- If a company fails or liquidates, common stockholders are paid after bondholders and preferred stockholders.
Preferred Stock
- A security that shows ownership in a corporation and gives the holder a claim, prior to the claim of common stockholders, on earnings and also generally on assets in the event of liquidation.
- Most preferred stock pays a fixed dividend that is paid prior to the common stock dividend, stated in a dollar amount or as a percentage of par value.
- This stock does not usually carry voting rights.
Treasury Stock
- Stock issued by a company but later reacquired.
- It may be held in the company’s treasury indefinitely, reissued to the public, or retired.
- Treasury stock receives no dividends and has no vote while held by the company.
The Dividend
A payment designated by the board of directors to be distributed pro rata among the shares outstanding. It can be made in either cash or stock.
- On preferred shares, it is generally a fixed amount.
- On common shares, the dividend varies with the fortunes of the company and the amount of cash on hand and may be omitted if business is poor or the directors determine to withhold earnings to invest in plant and equipment.
- A dividend is an amount paid to shareholders from a company’s after-tax earnings.
Capital Lease vs. Operating Lease
Capital Lease:
- Long-term lease
- Lower operating costs
- Both Lessor and lessee are allowed to depreciate the asset.
- Long-term liability on the balance sheet
- The airline is responsible for maintenance.
- Lease purchase option
Operating Lease:
- Short-term lease
- Higher operating costs
- Only the Lessor depreciates the asset.
- They do not appear on the balance sheet.
- The lessor is responsible for maintenance (engine, landing gear, and APU reserves).
- No lease purchase option
Vendor Financing
Manufacturers increasingly operate in a manner similar to an investment bank or as a Lessor.
- Airbus is a prime example of providing financial incentives to buyers.
- Ex-Im bank role: COFACE (France), Hermes (Germany), ECGD (UK), MITI (Japan), US Eximbank.
- Off-set agreements: financing the start-up costs
- Manufacturing offset agreements: revenue swap between the airline and manufacturing contractor.
Venture Capital
Some call it adventure capital.
- Venture capital investors will invest only in situations that will ultimately generate sizable profits or capital gains.
- Providing venture capital is risky and depends on the manufacturers to turn their ideas into a successful operation.
- Examples: Eastern Airlines in the 1930s, FedEx in 1973, People Express in 1980, COMAIR in 1980.
- The majority of venture capital investments are made by purchasing equity (stocks) or debt convertible to equity (bonds) in the start-up firms.
Balance Sheet
A balance sheet is merely a statement of assets and claims that summarizes the financial position of a firm.
- Assets are things of value that are owned: cash, property, and the right to property.
- Liabilities are monetary debts or things of value that are owed to creditors.
- Net worth (owner’s equity) is the difference between assets and liabilities.
- Assets = Liabilities + Shareholders’ Equity
Income Statement
The income statement is the most popular financial statement in an annual or quarterly report because it includes figures such as revenue, net income, and earnings per share (EPS).
- In essence, an income statement tells you how much money a company brought in (its revenues), how much it spent (its expenses), and the difference between the two (its profit/loss), over a specified time.
The Cash Flow Statement
There are different groups of people who read the financial statements, each looking for different types of information.
- Earnings might be the most important area for investors, but the statement of cash flow is extremely important to management, lenders, and tax authorities, as well as investors.
- Cash is the most important item in the operation of an airline.
- Cash flow could be used to accurately measure corporate success and dividend-paying ability than net income itself.
- Cash flow is a measure of operational flexibility because the airlines do not have to loan money from any sources for business expansions, such as new routes.
Current Ratio
An indication of a company’s ability to meet short-term debt obligations; the higher the ratio, the more liquid the company is.
- Current ratio is equal to current assets divided by current liabilities.
Return On Investment (ROI)
In finance, the return on investment (ROI), or just return, is a calculation used to determine whether a proposed investment is wise and how well it will repay the investor.
- Arithmetic return
- Return on investment is an accounting valuation method