Non-operating Activities
In contrast, the non-operating activities of CSA had been acting as an expense of the company in 2001. The drastic decrease from RMB 250 million in 2000 to RMB 605 million in the following year was due to the drop in gain on sale of aircraft under sale, the leaseback transaction as well as the loss on sale of staff quarter.
Net Profit
In the advent of the China government’s policies of improving the economic growth by endorsing the domestic demand, CSA has taken advantages from these implementations consistent with an amount of RMB 340 million net profit in 2001, however the net profit was in fact decreasing when compare with 2000.
Investing Activities
In accordance with the policy of Civil Aviation Administration of China (CAAC), there was a significant process of merger and restructuring. Indeed, CSA has proposed to restructure with China Northern Airlines and Xinjiang Airlines, which has been approved by the China government in early 2002. Undoubtedly, CSA will treasure this chance and persist to explore business opportunities arising from merger and restructuring in relation to the benefits of economies of scale.
Liquidity
In spite of this, CSA is actually taking a high risk to run the company repetitively. The firm’s liquidity is in fact getting worse and worse in view of the fact that there was an upsurge of the company’s fixed assets that had been using the cash of CSA and boosted up its loans too. Moreover, the current assets of CSA chopped down to RMB 4,378 million, whereas the current liabilities of the company had undesirably amplified to RMB 8,074 million from RMB 7,105 million.
Abstract
Consequently, it is clear that the company has realized the importance of the growth of assets. Yet, the managers should take all these decisions into a thorough consideration since the group’s ability to repay the debts has been deteriorating. Although there are guaranteed from the other parties for the loans in the previous years, it is apparent that if CSA is going to keep this trend forward, the creditors may not be willing to lend money to them and even those guaranteed parties may avoid to warrant CSA.
Ratios Calculation
Before examining the performance of CSA during the year of 2001, a brief understanding about the ratios of the company will be informative and my concerns are on two perspectives: profitability and liquidity of CSA. Other ratios of the company had been attached through Appendix 1.
Table 1:
The Profitability and Liquidity Ratios of China Southern Airlines
The calculations from the above table can give a brief idea about the performance of CSA. As a result, the following task will put its emphasis on the interpretation of these ratios in order to examine CSA’s operation
Analysis of Profitability
According to the Consolidated Profit and Loss Account in Appendix 2, the operating revenue increased by 11.2 % to RMB 16,879 million in 2001. Apparently, the domestic passenger revenue escalated by 14.2% under the above circumstances and while the Hong Kong passenger revenue has a minor fluctuation of –1.3%. Furthermore, the international demand grew up in line with China’s entry of the World Trade Organization (WTO). Consequently, the revenue in this perspective considerably expanded by 20.2%. Although there was a slight decline in the cargo and mail revenues as well as a reduction in the other revenue that was primarily ensue to a drop in the aircraft lease, the total operating revenue remained on its improving trend.
Then, the operating expenses saw a significant amplification of 10.6% that reached RMB 15,478 million in 2001. As a general rule, most of the operating expenses of CSA increased except the depreciation and amortization. In majority, the rise was the result of the operational growth and hence the substantial expenses of CSA are from its airline operations. The expenses in proportion to the operational growth include maintenance of increasing number of fleets; the added insurance costs result from the appalling terror in New York, increase in bonuses for flight personnel and so forth.
It is clear that the operating activities in CSA generated a desirable profit, thus, the operating profit increased by 18.5 % that can be shown by the gross profit ratio and mark up ratio. There was an upward trend for both ratios. However, the non-operating activities acted as a profit reducer for CSA in 2001. In the advent of the drop in sale aircraft, leaseback transaction and the loss on sale of staff quarter, CSA has to pay for RMB 354,546 million more than the previous year. As a result, this dramatic increase of expenditures reduce the net profit of the company and hence, the net profit ratio of CSA decreased by 1.4%. Therefore, the management team should pay attentions not only onto the operating activities, but also for the non-operating activities given that the above factors can directly influenced the net profit of a company.
In addition, the downward trend of the return on capital employed ratios implies that the entity’s profitability is getting worse and emphasis should be placed in order to protect the company’s growth and shareholder’s benefits. As long as CSA’s net profit kept on reducing throughout the next consecutive years, then the shareholders will seriously suffer. Even though the shareholders are not in a retrospective concern that means they do not only pay attention to the dividend payouts. Yet, it is important for the company to generate more profit and ensure a nourishing growth.
It is obvious that a company’s profitability can be affected by different angles. Definitely, the return on capital employed (ROCE) gives us a better understanding about CSA’s profitability, but it is vital to explore the components of ROCE. The following equation shows a clearer understanding.
ROCE = Return on Asset * Financial Leverage
Therefore:
ROCE = Profit Margin * Asset Turnover * Financial Leverage
First of all, the return on asset implies a company’s ability to use its assets to create profits. An upsurge of the ratio of course indicates CSA is using its assets well. However, from Appendix 1, the ratio tends to go down by 0.42% and it is mainly because of a noticeable cut of its profit margin within 2001. In reality, the profit margin of CSA decreased by 1.43% which represents the efficiency of CSA has gone downhill during the period. Moreover, it is clear to conclude that the cost control of CSA has been weakening in consistent with producing less profit from its sales. Subsequently, CSA has not converted its resources successfully when comparing with 2000. However, it seems that there was no choice for CSA to lessen its profit margin since the capacity of airline industry is almost full, the phenomenon of surplus and vigorous competition is presenting as a step-down transformer.
Apart from the profit margin, it is essential to explore the asset turnover since it is one of the pieces making up the return on asset. This ratio is in connection with the company’s capability to generate sales from its investment in assets. During the year of 2001, the asset turnover of CSA improved by 0.06. This minor growth vastly reduced the percentage loss in ROCE that also signified the superior management in CSA’s effectiveness. From the above analysis, it is evident that the sales of CSA increased and hence it has a higher asset turnover when weighing against the previous financial phase.
Finally, the financial leverage (FL) is concerning the capital structure; it is the use of debt to increase a company’s ROCE. From Appendix 1, it is clear that the net debt to asset has increased to 1.32 in 2001, so it means that the company has to pay more interests for its debts. Besides, when the debts of CSA increased, its total assets also went up as well as the financial leverage. If truth to be told, the financial leverage magnification factor favored the ROCE. In the advent of a positive value in the return on assets, the financial leverage magnifies the amount of ROCE. The following calculation shows the difference occur while using the financial leverage in 2000 and 2001.
Example 1:
Let the financial leverage of 2000 be 10 and the financial leverage of 2001 be 11,
Let the Return on Asset be 2.59%
ROCE = Return on Asset * Financial Leverage
ROCE (A) = 2.59 *10 = 25.9
ROCE (B) = 2.59 * 11 = 28.49
From the above example, it is clear that when the financial leverage increases, the return on capital employed increases too, providing that the return on asset is positive. Furthermore, the financial risk will increase the risk of the shareholders; accordingly, the decreasing trend in ROCE will have a bad effect in the shareholder’s point of view. It is because of the financial leverage just saved CSA from suffering of a greater decrease in ROCE instead of boosting it up.
Dividend is invariably the most important concern of the shareholders. They are the one who finance the company and would like to attain benefits through their investments. Also they realized that CSA is a high-risk company when they first invested, as its operation and financial leverages are high. Incontrovertibly, they would like to earn more from the long-run profits and stock value and of course the investors will expect a higher return from a high-risk company – CSA. Recently, CSA is on its growing stage, therefore the decision of dividend payout at the moment will not cause any harmful effects, such as no dividend will be paid this year. In long, CSA must ensure a sufficient level of profit to for the payment of dividends or for reinvestment to heighten a greater stock value.
Analysis of Liquidity
As stated by the Consolidated Balance Sheet in Appendix 3 and 4, the current assets decreased to RMB 4,378 million in 2001 and the fundamental reason was mainly due to the significant drop of cash and cash equivalents from RMB 4,197 million in 2000 to RMB 2,817 million in 2001. On the other hand, the quantity of bank and other loans increased from RMB 783 million to RMB 2,177 million radically that led to an incline of RMB 969 million and reached another peak of RMB 8,074 million.
The enormous amount of money used in 2001 is attributable to the acquisition of the non – current assets through paying the lease and equipment deposit along with investments in jointly controlled entity and associated company. CSA has spent additional RMB 1,827 million and RMB 174 million on the above issues respectively. Obviously, the added amount of liabilities and the reduced amount of cash were based on the delivery of two new Boeing 747-400 freighters, the full year effect of five Boeing 737-300 / 37K aircraft wet leased from Zhongyuan Airline plus the investment in associated company and jointly controlled entity.
Moreover, the current liabilities as at the end of 2001 inclined to RMB 2,177 million since there are significant amount of earlier borrowings in 1998 come to the due date, which was the time of the Asian Economic Crisis. Resulting from the huge outflow of cash as well as a great pressure from the previous loans, the current ratios of CSA fell down considerably.
From the ratios calculated in the previous task, there is no doubt to reckon that the liquidity of CSA is on its edge. The current assets ratio in 2000 was already in a threatening position with the value of 0.83, meanwhile the ratio further diminished to 0.54 in 2001. It is indisputable that the current ratio of a company should at least equal to one. If this were not so, and creditors pressed for payment, some fixed assets would have to be sold, grinding down productive capacity as long as loan could be negotiated. In this circumstance, creditors tend to impose the debt covenants that are limitations for CSA to borrow extra money since they would like to reduce the faced risks.
In addition to the current asset ratio, the acid test provides a more transparent insight to CSA’s liquidity. Stock is an asset, which is hard to transfer to cash and it takes time to do so. After reducing the stocks from the current asset, the ability of CSA to repay for its debt arrived to a new bottom point that is 0.48. Although it is relatively better than the current asset ratio since the percentage amendment is comparatively lower, it still suggests that the position of CSA to meet its current liability obligations is lower since the ratio decreases substantially over time.
In details, it is reasonable to investigate the cash flow of CSA with the year and identify how did it use its cash for and eventually affected its liquidity. Apparently, the net cash used in the investing activities vastly rose up according to Appendix 5 and from Appendix 1, the ratio of investment cash flow to assets climbed up by 9.07 %. As I have mentioned before, most of the money has been used in the payment of lease and equipment deposits.
Unquestionably, the growth in assets will assist further expansion in sales since the production capacity multiply correspondingly, and hence additional profits may be created. However, it is vital to the management team that the demand of aviation fluctuates all the time and as the industry is dynamic, the risks accompanied increased too.
Financial Position of China Southern Airlines
Throughout the year of 2001, CSA successfully used its added fixed assets to generate more operating profits. By means of leasing more fleets and equipments, the production capacity enlarged. Surprisingly, the total assets of CSA has decreased by RMB 270 million in 2001, which is chiefly due to the significant outflow of cash in this particular year. On the other hand, the aggregate liabilities of CSA have a negligible flux. Hitherto, the preceding long-term liabilities has come to the due date, as a result, it converts to the current liabilities. Eventually, this leads to a great increase of net current liabilities and put CSA’s financial position at risk.
From the previous sections, the current assets ratio of CSA was less than the desired value, which was less than one as well as going down greatly. Also, the current liabilities of CSA were inclining too. Apart from the current assets ratio, the acid test ratio showed a more depressing result with the value of 0.48 that meant CSA was running into a more serious liquidity problem.
Furthermore, the amount of cash and cash equivalents significantly dropped down which supplementary weaken CSA’s financial position. However, the accounts payable of CSA decreased from RMB 758 million to RMB 590 million in 2001, and thus, the creditors may have more confidence towards CSA as it was able to pay back its operating credit sales. Besides, the inventory level of CSA just fluctuate a bit from RMB 464 million to RMB 467 million. In relation to the appalling external environment, this minor fluctuation of stocks may act as another protecting tool for CSA since the creditors will have more assurances towards the operating activities of the airlines.
Another important factor towards CSA financial position is the debts of the airline, from Appendix 1, the net debts to assets ratio indicated that the net debts of CSA were raising. Yet, two of the non-current liabilities, which contributed to the interest payments, were decreasing and they are: Bank and other loans plus obligations under finance leases. These two changes will certainly assist CSA from paying the interest expenses. There is no doubt that less interests will be paid in the next financial period under this circumstance that will improve the financial position of the firm.
Comments
In my own point of view, there are other forces that will affect CSA’s performance in the coming years. Definitely, the previous performance will influence its coming functioning. Nonetheless, the external and internal environment will also have influences toward CSA’s operations.
At the outset, it is unarguable that the economic environment will have direct impacts. The loans of CSA have been denominating by the foreign currencies; as a result, the foreign exchange rate of the other currencies against RMB will be one of the important factors affecting CSA’s profitability. In case RMB appreciates in the coming fiscal year, CSA will enjoy a gain in paying less interest.
Despite that, the global political issues will exert certain weights into CSA’s progression too. Jet fuel, which is a non-avoidable cost for flight operation, and its price has grew up drastically since the United States and United Kingdom are fighting again Iraq. The war will force the price to go upwards, and hence, the operating costs of CSA will increase accordingly. Furthermore, the insurance premium of the flight will reach another peak after the outrageous 911 terrorism since the insurance companies have to compensate for the travelers. Undoubtedly, the rise of insurance will appear as an added cost for CSA.
In addition, the grisly and frightful atypical pneumonia. This disease was originated in China – Guangzhou, that is the headquarter of CSA. In fact, government of different countries are persuading their citizens to keep away from traveling to the infected areas, especially China, Hong Kong, Vietnam and so on. In addition to the word of mouth from the medias and government, it has been proved that the awful pneumonia can be spread out easily on board. Subsequently, the foreigners may forestall themselves from traveling by the plane. Instead, alternative mode of transports may be used while traveling as well as avoiding travel by the Chinese carriers or take a trip to China. Obviously, the demand of CSA services will decline and hence, it is important for the management staffs to further evaluate its position and how to maintain a reasonable amount of profit.
Other than the above aspects, internal circumstances are tactic effects for CSA’s further expansion too. I am going to put my focus on the suitable choice of operating strategy. In reality, CSA is trapping in between the product differentiation and cost leadership.
If CSA is planning to increase its financial leverage (Net debts to assets has been increasing) in order to attain an increase in the return on capital employed, the management board must ensure that the return on assets is positive.
Without a doubt, the profit margin of CSA cannot be easily boost up in this new era because of the over supply and intense contest among the aviation industry. Thus, it is essential for CSA to increase its effectiveness in order to maintain a satisfactory level of return on capital employed. By promoting low fare services in bulk and increase its sales volume to create more profits. However, I will suggest CSA to keep its emphasis on product differentiation. By building a better brand name, loyalty of customer and employee, special service and quality management, CSA may success.
The impressions of China in the foreigner’s perceptions are always underdeveloped, unclean, disrespect and etc. Therefore, CSA can try to promote its services by emphasizing hygiene and qualitative services.
Under the above advertising idea, the foreign travelers will at least realize that one of the Chinese carriers called CSA are cleaner than the others and the chance of infected by pneumonia will be lower while traveling on board. In due course, they will choose to travel by CSA instead of the other carriers. By earning a higher profit margin, the return on capital employed will also increase. Hence, CSA financial position can then be enhanced.
Last of all, CSA can choose to integrate vertically with the aircraft and equipments manufacturers. Via backward integration, CSA can escape from the massive amount of lease payments, interests, as well as the deposits. Lease is similar to the long-term debts; it is indispensable for CSA to pay for the principals and interests. After the integration, cost can be efficiently controlled. However, CSA must keep in mind that authorizing preference shares during the liquidity period will not help, in contrast, the current situation may be worsen. Overwhelmingly, CSA will have to make dividend payments to the preference shares. Also, the ordinary shareholders will be a bit riskier because of the dividend and liquidation preferences of the preferred stocks.
Finally, it is a key to success for CSA to have a good communication with the public sector. On condition that more co-ordinations in between the China Government, Aviation Organizations, other airlines and CSA, professional ideas can be acquired that can basically assist CSA to understand more about the current propensity, marketing strategies as well as attaining assistance from the government.
Conclusion
In conclusion, CSA is growing with an eye-catching potential. In relation to the greatest volume of passenger traffic, number of scheduled flights per week, number of hours flown, number of routes and sizes of aircraft fleet, there is no hesitation to say that CSA is being one of the most important airlines in China.
However, success is always accompanied with obstacles. There are a lot of hedges in front of CSA for the further expansion, including the intense competition among the industry, increasing operating expenses (e.g. jet fuel), other external environmental factors and so forth. It is definitely a hard task for CSA to fend off all these hedges. Nevertheless, by implementing the suitable operating strategy, CSA can eventually enjoy a better return on capital employed, as a minimum at an improving trend. Furthermore, necessary planning is essential at any stage of operations and especially at the top management level.
Evaluating the strength and weakness of CSA is at first the most significant step. Afterwards, the management board should make good use of the assets of the company, for instance, cash, and create as much profit as possible for the shareholders through the payment of dividends or reinvesting the operating profits to strengthen its productivity.
Other than the above mentioned, the management team, and leaders in CSA should be adaptable enough to accommodate any sudden issues that will affect CSA’s performance like atypical pneumonia.
As a final point, the entire CSA should pay more concern onto the customers since the aviation industry is for eternity customer oriented. Building up good relationships with different stakeholders, such as suppliers, customers and employees will favor the further operational enlargement and aid CSA to another peak within the airline industry.
Reference:
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Dyson, J. R. Accounting for Non-Accounting Students (5th ed.). Ashford Colour Press Ltd.
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Bull, R. J, Harvey, David A & Lindley, Lindsey M. Accounting in Business (6th ed.). Great Britain, Kent: Mackays of Chatham PLC