Ratio Analysis and Stock Returns
Starting service to a new market, such as Havana, Cuba, is a major capital budgeting project for Southwest Airlines (ticker symbol: LUV). A project of this scale requires coordinated planning across all functions of a business that you are studying in your Integrated Core classes. Choose and discuss three items on the income statement and balance sheet that you think will be impacted by this new undertaking (a total of six items). Explain why you chose those particular items, and how those items are impacted by the marketing, management and operations decisions of the company.
Income Statement Items
Advertising costs which may lower the overall net profits
As the company penetrates the new market, it has to embark on extensive marketing to inform the prospective customers about the presence of the company in the country. Marketing in this case would include airing adverts through the local Cuba media, personal promotion and road shows, philanthropic works, and social media marketing among others. These marketing endeavors would cost the firm a substantial amount of money which must be offset against its profits (Higgins, 2012). This item is selected because it may have a negative effect on the net profits of the firm. The firm may lower these costs by entering into merger and acquisition agreements with the airlines operating in the region to alleviate the need to extensively market itself.
Salary and wages
In addition to the increased marketing costs, the company may need to hire more staff to coordinate the operations in the new market. The new employees would include pilots, clerks, and marketers among others. Hiring new employees would lead to increased salaries and wages which are equally offset against the profits of the firm (Penman & Penman, 2007). This item of balance sheet is selected because it may lead to increased operations costs which may lower the profits of the firm. The company could repatriate the already existing staffs instead of hiring new ones in order to reduce the effect that this item of cost would cause on the profitability of the firm.
Lastly, the firm would need to make some borrowings to finance the increased operations. The borrowed finances would increase the cost of capital leading to inflated interest costs. This item is selected because the firm is likely to consider financing the new venture using debt capital because the mentioned type of finance is easy and fast to obtain compared to other types of capital (Higgins, 2012).. The firm could, however, make suitable operational decisions to eliminate the interest costs. The company, for example, can issue new equity instead of using loans. As opposed to loans which must be repaid with interests within a specified period of time, equity capital attracts dividends which the firm must not pay if it does not make enough profits.
Ratio Analysis and Stock Returns
Balance Sheet Items
Long term liability
As stated above, the company may have to rely on debt capital to expand its operations into Cuba. The borrowed capital would increase the overall long term liability for the firm. Given that such liabilities are listed as balance sheet items, it would lead to imbalance of the company’s assets and liabilities. This balance sheet item is selected because it may have a profound impact on the company’s balance sheet (Higgins, 2012).. In the contemporary accounting, a firm’s financial leverage is determined by analyzing certain ratios such as the debt ratio. If the debt ratio is high, then investors may be reluctant to invest in the firm due to fear of its possible liquidation in the future.
The new investment will lead to an increase in the value of fixed assets. The view is grounded on the fact that the company must procure additional planes to facilitate the increased operations. This item is selected because an increase in the fixed assets increases the value of the firm and may greatly impact how investors view a firm. Additionally, the decision to procure a fixed asset is a major one and at time may require approval by the shareholders (Fraser, Ormiston & Fraser, 2010). The operational decision to expand operations to Cuba obviously necessitates procurement of additional planes to effectively serve the new route.
Earnings per share
The firm’s earnings per share would be affected either positively or negatively depending on the ability of the investment to produce enough results to pay the capital costs. If the investment results in increased profits of the firm, then the dividend payout will be high. If the investment does not yield enough profits to remedy the extra cost, then the dividend payout may be low. This item is selected because it is likely to spark conflict of interest between the shareholders and LUV’s executives (Fraser et al. 2010). It is important to note that shareholders are usually interested with what they earn as dividends and are never bothered about the interest of other stakeholders. The new venture may lead to increased operations costs which may lower the dividends payable to the shareholders.
Choose and calculate five ratios for this company for the last two years. Make sure to select ratios that you think would be impacted by starting new service to Cuba, and explain your reasoning. Identify two competitors of LUV and contrast the ratios. Explain why you selected those competitors. Describe how the decisions made by management, marketing and operations functions of the company can impact, and hopefully improve, these financial ratios.
Debt to Equity ratio
This ratio is obtained by dividing the total Liabilities by shareholders equity. The ratio informs interested parties about the amount of debt a company is using to finance its assets in relations to the shareholders value (Higgins, 2012). If the ratio is high, then the company is using more de