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Total Points: 50.0
INTRODUCTION Financing billions of dollars in flight and ground equipment in the new century presents a tremendous challenge to the airline industry. Airline earnings tend to be cyclical, and industry returns on investment generally have been poor (see Table 16-1). With a few notable exceptions, airline cash flows over the long run have been inadequate to meet capital requirements. At the same time, the ratio of debt to equity for many carriers has increased to levels that have had a negative impact on their creditworthiness. Not only has this limited access by these airlines to external funds, but it has also led to larger option fees and progress payment requirements from the manufacturers—as much as 25 percent of the aircraft price in a three- to four-year period before delivery. The advent of deregulation changed the basic rules of the game for air carriers. Deregulation has increased the demands on management for marketing skills, strategic planning, cost control, and competition with other firms. Deregulation stemmed in part from a belief that airlines, like other firms, should earn their own way in the market, not look to a public body or policy to guarantee it. It might then be appropriate to ask why, in a deregulated environment, one should be concerned with the financial condition of the airlines. The financial condition of the industry directly affects individual firms’ behavior in the short run and, ultimately, their structure and performance in the long run. In the short run, failing firms may resort to less-than-compensatory fares to generate sufficient cash to cover their fixed short-term commitments but not their long-term costs. This may threaten, in turn, the profitability and survival of other carriers in the long run. Although passengers benefit from low fares in the short run, for well-operated carriers to survive, fares must be raised eventually to recoup losses and provide a sufficient return to keep capital in the industry. Furthermore, the disruption to air service caused by the failure of a particular carrier imposes real costs on passengers, both business travelers and pleasure travelers. In the long run, whereas the survival of any one firm is not important on a national policy basis, the failure of a significant number may lead to increased concentration and too few firms in the industry. The minimum number of firms necessary to ensure a competitive industry has been widely debated. As important as that number, however, is the degree to which the existing airlines serve the same markets and the vigor with which they compete on price and service. A small number of nationwide firms that compete with one another at all the large commercial airports may provide much stronger competitive pressure to hold down costs and fares than a large number of carriers competing in less extensive networks. The fewer the number of firms, however, the easier it is for them to form and enforce a tight oligopoly in which industry output is lower and fares are higher than would be the case in a competitive market.
CASH MANAGEMENT AND FINANCIAL PLANNING At several points in this chapter, we have mentioned the importance of cash holdings as part of working capital. Certainly, one of the primary reasons for the demise of Eastern Airlines was the fact that it became cash starved and simply could not pay its bills. Airlines take in and spend millions of dollars daily. Apprehensive about Eastern’s financial problems, travel agencies diverted millions of dollars in ticket sales to other carriers in order to protect their customers, despite assurances from Eastern management almost up to the day they called their fleet home. In many respects, cash is the most important item in the operation of an airline. It is both a means to and an end of the enterprise. Return on investment takes the form of a payment of cash dividends, and in the event of liquidation, cash becomes the final medium by which claims are discharged. Cash is one of the most important tools of day-to-day operation, because it is a form of liquid capital that is available for any use. Cash is often the primary factor in the course of an airline’s destiny. The decision to expand may be determined by the availability of cash, and the borrowing of funds, as was stated earlier, may be determined by the carrier’s cash position. There is never a time in the life cycle of an airline that cash, or the ready access to it, is not important. However, it is of particular importance for a fledgling carrier to have an adequate supply of cash. Payrolls must be met; contracted maintenance sources must be paid; fuel suppliers will not tolerate an extension of credit in today’s environment. Unexpected costs incurred as a result of poor weather and many other events require cash on hand. Lacking cash, a carrier’s operations are slowed, if not paralyzed. Creditors press the collection of their claims. If payments cannot be made or adjustments effected, bankruptcy and failure follow. Even after a company has overcome its initial financial growing pains, the daily cash position continues as a key factor in its operations. Some major carriers maintain large liquid cash balances in excess of their immediate needs and prefer to borrow little, if at all, on their current account. But other carriers are not in this position and must frequently borrow their seasonal working capital requirements.
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