Transcript ESSENTIAL ACCOUNTING REPORTS

WELCOME TO
ACCOUNTING AND FINANCE
"I'll tell you, Harris, they don't make accountants like they used to.
Those I had in the 1990s never brought me figures like these."
Cartoon by Dave Carpenter
Copyright 2002, Harvard Business Review
ACCOUNTING AND FINANCE
OBJECTIVES
ACCOUNTING
Recording and Reporting Financial Activities
Three Reports and Analytical Metrics
FINANCE
Sources of Funds: Internal, Debt or Equity
Implications of Funding Sources on Firm
Governance and Value
ACCOUNTING AND FINANCE
Definitions
Accounting’s Function:
Recording and Reporting
Firm’s Financial History
Finance’s Function: Managing
Firm’s Capital Structure
ACCOUNTING AND FINANCE
Accounting’s Focus
 Consistency:
Financial Reporting that
supports Comparative Decision-Making
 Regulation: Detect Non-Compliant or
Unacceptable Practices
 Taxation: Adjustments that convert
Profits into Income
ACCOUNTING AND FINANCE
Finance’s Focus
Reconcile Sources and Uses of Cash:
Match
Timing and Amounts of Operating and
Capital Needs
Evaluate Implications of Capital Structure
Choices: Impacts of Rights and Claims of
Funding Sources on Governance and Value
ESSENTIAL ACCOUNTING REPORTS
Balance Sheet
Income Statement
Statement of Cash Flows
BALANCE SHEET
 Reports Assets, Liabilities and Equity
 Assets: Property Owned by Firm
 Liabilities: Debts and Financial Obligations
(Specific Claims)
 Equity: Stock Sales/Investments and
Retained Earnings (Residual Claims)
 Reports Financial Condition as of Specified Date
(Month/Quarter/Year End)
 Amounts reported at Lower of Cost or Market Value
ESSENTIAL ACCOUNTING CONCEPTS
The Accounting Equation
Assets = Liabilities + Equity
Variation for Business Valuation:
Equity = Assets – Liabilities
INCOME STATEMENT
Reports Revenues, Expenses, Profits
and Income
Profits are Financial Results of Firm’s
Operations
Income includes Allowable Adjustments to
Profits for Tax and Investment Reporting
Information Reported for Prior Period
(Month, Quarter or Year)
ACCOUNTING QUANDRIES
Which Rule Provides Better Information?
Transactions that are reported when…
Cash is Received or Paid (Cash Basis) or...
Services or Products are Performed (Accrual Basis)
 GAAP says Report Transactions when Primary Purpose

accomplished (Payment not relevant)
Business Management and Creditors concerned when
Cash Received or Paid
STATEMENT OF CASH FLOWS
Reports Sources and Uses of Cash …
Categorized by Activity
OPERATING – Cash generated by and used in
Core business
INVESTING – Cash used to purchase Assets and
generated from Selling Assets
FINANCING – Cash used to pay Debts or
Dividends and generated from borrowings or
Equity Investments
Nike: Intangible Assets and Preferred Stock
NOTE: Preferred Stock and
“Classes” of Common Stock
GOOGLE: Common Stock Classes
Note 11. Stockholders’ Equity In April 2006, we issued 5,300,000 shares of
our Class A common stock upon the closing of a follow-on public stock
offering for net proceeds of approximately $2,063.5 million.
CLASS A AND CLASS B COMMON STOCK
Our Board of Directors has authorized two classes of common stock,
Class A and Class B. At December 31, 2006, there were 6,000,000,000
and 3,000,000,000 shares authorized and there were 227,670,374 and
81,327,112 shares legally outstanding of Class A and Class B common
stock. The rights of the holders of Class A and Class B common stock are
identical, except with respect to voting. Each share of Class A common
stock is entitled to one vote per share. Each share of Class B common
stock is entitled to ten votes per share. Shares of Class B common stock
may be converted at any time at the option of the stockholder and
automatically convert upon sale or transfer to Class A common stock.
ACCOUNTING ISSUES: AUDITOR’S OPINION
REPORT OF INDEPENDENT PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders
We have audited *** Southwest Airlines Co. *** for the period ended
December 31, 2006. 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.
*** 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 ***
presentation.
In our opinion, the financial statements *** present fairly, in all material respects,
the consolidated financial position of Southwest Airlines Co. *** in
conformity with U.S. generally accepted accounting principles.
Ernst & Young LLP Dallas, TX January 30, 2007
ACCOUNTING ISSUES: SOX CERTIFICATION
I, Laura H. Wright, Chief Financial Officer of Southwest Airlines Co., certify that:
1. I have reviewed this annual report *** of Southwest Airlines Co.;
2. Based on my knowledge, this report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements *** not misleading with respect to the period covered
by this report ***
5. The registrant’s other certifying officer(s) and I have disclosed *** to the
registrant’s auditors and the audit committee of the *** board of directors:
(a) all significant deficiencies and material weaknesses in the design or
operation of internal control over financial reporting which are reasonably
likely to adversely affect the registrant’s ability to record *** and report
financial information; and
(b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant’s internal
control over financial reporting.
THREE ESSENTIAL METRICS
Current Ratio
Debt-to-Equity Ratio
Return-on-Equity Ratio
THREE ESSENTIAL METRICS
CURRENT RATIO
Measures Firm’s Liquidity; Calculates Relationship
between Available Cash and Short-Term Liabilities
(less than 1 year until due)
FORMULA: Current Assets  Current Liabilities
ANALYSIS: Minimum Level - 1.2:1
Analyze Trends: Changes caused by
decreasing cash or increasing liabilities?
THREE ESSENTIAL METRICS
DEBT-TO-EQUITY RATIO
Evaluates Capital Structure: Mix of How Firm is
Financed – Debt versus Equity (“Leveraging”)
FORMULA: Debt  Equity
ANALYSIS: Debt requires Mandatory Periodic
Cash Payments; Equity does not
Evaluate Mandatory Fixed Cost Burden
THREE ESSENTIAL METRICS
RETURN-ON-EQUITY
Measures Rate of Return produced by Firm for its
Equity Investors
FORMULA: Net Income  Shareholders Equity
ANALYSIS: Measure of Return from Investing in
Aggregate Risks of Firm Management,
Product and Market Share
Note: Not Return-on-Investment (individual
shareholder returns)
FINANCE: What you need to know…
“Debt is like Cholesterol:
There’s “Good” Debt and
There’s “Bad” Debt”
Cartoon by Dave Carpenter
Copyright 2004, Harvard
Business Review
FINANCIAL MANAGEMENT
RECONCILE SOURCES/ USES OF CASH
Operating Needs: Timing and Amounts
Capital Needs: Growth, Contraction or New
Enterprises
Internal and External Contingencies
Strategic Equilibrium: Assets’ Profit-Producing
Characteristics versus Capital Structure’s
Costs and Implications
CAPITAL STRUCTURE
FINANCING will be obtained either
INTERNALLY or EXTERNALLY
 Choice depends on Timing, Available
Amounts and Costs to Obtain and…
 Implications for Operations (Debt’s Specific
Claims on Cash Flows/Assets) and
Governance (Common Stockholders’
Right to Vote)
“Howard, Think about your Capital Structure…”
CAPITAL STRUCTURE
INTERNALLY GENERATED FINANCING
Retained Earnings (No Dividend Payout)
Vendor Financing (Accounts Payable) or
Sales Terms (Accounts Receivable)
No Application/Approval Process
Immediately Available
No Cash Flow/Governance Implications
CAPITAL STRUCTURE
EXTERNAL FUNDING: DEBT
Obtained from Commercial Banks, Finance
Companies and Private Parties
Subject to Creditworthiness/Debt Servicing Capacity
Negative Covenants: Restrictions on Other
Borrowings, Profitability, Current Ratio and more
Cash Flow Implications: Repayment Terms, Interest
Charges, Fees, Reports and more…
DEBT VERSUS EQUITY
DEBT
Rules-Based: Negotiated ex ante and
documented in legally binding contract
Repayment required on Date Certain
Periodic Debt Service
Lender’s Claim limited to Loan Amount and
Claim on Asset(s)
CAPITAL STRUCTURE
EXTERNAL FUNDING: EQUITY
Public Equity: Obtained from Investment Banker
through Initial Public Offering (IPO)/Stock Issue
or Private Equity: Venture Capitalist
Sale of Fractional Ownership: Cost is tradeoff
between Capital received and Control Given Up
Control Rights: Employment Agreements, Board
Memberships, Decision-Making,Voting Interests…
DEBT VERSUS EQUITY
EQUITY
Discretion-Based: Negotiated for ex post
application, but Actions not specified
Repayment and Dividends not required
Consideration for Investment includes
Limited Liability and Voting Rights
FINANCIAL MANAGEMENT
CAPITAL STRUCTURE: IMPLICATIONS
Internal Funds (Retained Earnings)
 Shareholder Expectations
External Debt (Bonds and Loans)
 Covenants may restrict Growth; Rate Risk
External Equity (Sale of Ownership Interest)
 Voting Rights
The “Magic” of Leveraging
Earnings per Share (EPS)
versus
Capital Structure
• 50% Increase with 50/50
• Triple with 80/20
What happens if (or when)
Revenues decrease to
$850?
Does it help to reduce
Interest Rate to 5%?
Southwest’s
Business
Plan
June 18, 1971: Began Service
(Organized in 1967)
May 2003: Largest Domestic Carrier
More than 3,300 Daily Flights – 64%
Market Share
Flies only Boeing 737 Jets: 530 Planes in
Fleet. Each flies 13 hours (7 flights)/Day
Busiest Destination/Departures: Las Vegas
82% Unionized (73% at General Motors)
Average Fare: $106.60 – Sold 88.7 Million Rides
1Ticket sold every 21.3 seconds
2006: Received 284,827 Resumes
Hired 3,363 New “Southwest Warriors” (85:1)
Consumed 1.489 Billion Gallons of Jet Fuel
Average price paid: $1.70 per Gallon
Served 61.5 Million Cans of Soda/Water,
10.9 Million “Adult Beverages” and 93.8
Million Bags of Peanuts
Does Capital Structure Matter?
Debt-to-Equity (“Leveraging”) Ratios (2006)
Southwest
Northwest
Jet Blue
Continental
$1.42 to $1.00
$5.40 to $1.00
$5.50 to $1.00
$31.59 to $1.00
What has Southwest NEVER done since it started?
Answer: Lost Money. Profitable for 35
Consecutive Years
Let’s “dive into” some of Southwest’s Numbers…
Revenues: 96% from Passenger
Ticket Sales
Salaries: 35% (2007) versus
41% (2005)
Taxes:
39% Effective Rate
Fuel Expense
Average
Cost
Per
Gallon
Percent of
Operating
Expenses
Year
Cost
(Millions)
2007
$ 2,536
$ 1.70
28.0%
2006
2,138
1.53
26.2%
2005
1,341
1.03
19.6%
2004
1,000
0.83
16.3%
2003
830
0.72
14.9%
Comparative Ratio Analysis
2007
2006
Current Ratio
0.92:1
0.90:1
Debt-to-Equity Ratio
1.42:1
1.09:1
9.3%
7.7%
Return-on-Equity Ratio
Valuation Analysis
Stock Price (April 22, 2008)
$ 11.78
Market Value (807,611,634 Shares)
$ 9,514 M
Book Value (Total Stockholders’ Equity
$ 6,941 M
Market Value Premium over Book Value
137%
Earnings per Share ($645/807.6)
$ 0.80
Stock Price Multiple ($11.78/$0.80)
14.73
Note Reconciliation of
Beginning/End of Period Cash
with Balance Sheet Cash
Asset Purchases always
Financed with Cash from
Operating Activities
Fleet consists of 530 aircraft (all
are Boeing 737s): 36 were
purchased in 2006 and 39 were
purchased in 2007
2008 plans call for purchasing 29
aircraft and returning or selling
22 aircraft
Fuel Derivative Contracts in place
protect against over 70% of 2008
anticipated jet fuel requirements
at average price of $51/barrel
Contracts are in place for 55% of
expected fuel consumption for
2009 at approximately $51/ barrel.
ACCOUNTING AND FINANCE
ACCOUNTING: FUTURE CHALLENGES
Know and Evaluate Results of Decisions
Complexities of Product Development/Globalization
FINANCE: FUTURE CHALLENGES
Integrate Assets with Balance Sheet’s Right Side
Develop Financing Methods for Innovative Growth:
Intangible Assets and Knowledge-based Work
Why Didn’t
Anyone See
This
Coming?
Stock Price
January 3, 2000
Significant Events
$ 43.44
August 2001
CEO Skilling Resigns (October 2006:
Sentenced to 24 years in Prison)
August 17 and 23, 2000
90.00
November 2001
Earnings for past 4 years restated;
Bond rating reduced to “Junk”
December 29, 2000
83.13
December 2, 2001
Chapter 11 (Reorganization) Bankruptcy
Petition filed
October 29, 2001
13.81
January 1, 2004
Bankruptcy Petition converted to
Chapter 7 (Liquidation)
November 30, 2001
26¢
Would studying
Enron’s
Statement of
Cash Flows and a
Little Common
Sense have saved
Billions?
Note 9. Supplemental
Cash Flow
Information
Cash Payments for Income Taxes
[Federal Rate: 35%; *Effective Rate]
2000: $62 (4.4%*)
1999: $51 (5.1%*)
1998: $73 (8.3%*)
Note 16. Related
Party Transactions
“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
transactions * * * were reasonable compared to those which could have been negotiated with
unrelated third parties.”
Nota Bene
Contrast 1998 and 1999 Cash Sources (Operations: 1/3 and Financing: 2/3) with 2000 Cash Sources