Southwest Airlines Co.

:
Credit Analysis and Financial Flexibility in the Era of COVID-19 1

Southwest Airlines was founded in 1967 by Rollin King and Herb Kelleher to fly between the
three major cities in the “Texas Triangle”: Dallas, San Antonio, and Houston. After several years
of lawsuits from competitors, Southwest made its first flight in 1971. 2 It expanded to western and
southern states outside of Texas starting in 1979, going nationwide by the late 1990s. Around the
turn of the millennium, Southwest began adding longer hauls to compete with the major airlines,
and it bought up routes from smaller carriers like Morris Air and AirTran. Today it is one of the
“Big Four” U.S. airlines alongside United, Delta, and American Airlines.

Southwest became a pioneer in Point-To-Point Service. While major airlines utilized a hub-and-
spoke model, where flights came and went in high volume around peak times to major airports,
Southwest chose to fly shorter “point-to-point” routes to small cities and second airports within
major cities. Southwest made up for the higher costs per mile by delivering faster turnaround times.
In 2002, Southwest had the fastest average turnaround of any U.S. airline at 27 minutes. 3

Southwest’s focus has always been on domestic flights. While the airline has expanded to
international destinations in the past decade, the company continues to fly only in North America,
avoiding the transatlantic hauls that require costly fuel and personnel. The airline sought to bring
a low-cost mindset to every aspect of its business. It offers fewer amenities for its flights, with no
first-class seating or meal offerings onboard, and it uses only one plane model, the Boeing 737,
for all of its flights. The company also limits costs for customers, with free checked bags and no
ticket change fees. While the company’s fares have increased with longer hauls, it maintains its
no-frills experience today.

While the airline’s lack of amenities and first-class upgrades does not appeal to solo business
travelers, its more diversified destination offerings make it very popular among family leisure
customers. The flights from smaller cities, the Companion Pass rewards offering (in which a
designated companion can fly free for one year), and the zany employee culture all make
Southwest a hit with leisure customers. The company’s longer-haul and international expansions
to Hawaii and the Caribbean serve that market. As Southwest expanded in the 1980s and 1990s,
the company practiced controlled growth, limiting itself to a 10-15% growth rate per year to

1
This case was prepared by Michael Minnis and Abbie Smith at the Booth School of Business at the University of
Chicago. This case was produced for illustration purposes only and is not intended to establish valid predictions of
firm performance. We sincerely thank John Lyons and Richard Zhao for excellent research assistance.
2
David Brown, “Southwest vs. American – Clearing the Runway,” Business Wars, Podcast Audio, September 11,
2018, https://www.stitcher.com/podcast/wondery/business-wars/e/56237395
3
Jan W. Rivkin and Laurent Therivel, “Delta Air Lines (A): The Low-Cost Carrier Threat,” HBS Case No. 9-704-
403 (Boston: Harvard Business School Publishing, 2005), p. 2.

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 Southwest Airlines Co.: Credit Analysis and Financial Flexibility

“manage in good times in order to survive the bad times.” 4 This strategy also limited the yearly
capital expenditures and leverage the company needed to carry in its financial statements.

Perhaps the biggest differentiator between Southwest and other airlines is Southwest’s employee
culture. Since the company started flying, Southwest has had only three CEOs: Herb Kelleher,
from 1971 to 2001; James Parker, from 2001 to 2004; and Gary Kelly, from 2004 to today.
Kelleher was the primary influence on the company’s culture, something which Parker and Kelly
maintained after Kelleher retired. Southwest makes a strong statement of culture and purpose,
and it states its vision “to be the most loved, most efficient, and most profitable airline,” showing
a combined focus on customer satisfaction and shareholder value. It also emphasizes a “Fun-
LUVing Attitude,” with flight crews that are known to sing and deliver entertaining monologues
during safety briefings. The attitude reflects its strong employee culture, which contrasts with the
contentious company-crew relations at other airlines. Every employee promises to “demonstrate
my Warrior Spirit by striving to be my best and never giving up.” CFO Tammy Romo discussed
“Warrior Spirit” in December 2018, saying, “Being able to respond to forces we cannot plan starts
with being prepared.” Romo felt that this spirit helped the company through the worst economic
periods, stating, “even in the wake of 9/11, we managed to make a profit in the fourth quarter of
2001. And, unlike many of our competitors, we did so without laying off employees or cutting
their pay.” 5 Less than a month after Romo made these comments, Herb Kelleher died. Her
sentiments reflected Kelleher’s attitude on employee relations, which he reflected on in 2013: “we
could have made more money if we’d furloughed people during numerous events over the last 40
years, but we never have. We didn’t think it was the right thing to do.” 6

All these factors have made Southwest one of the only consistently profitable airlines in the
country. While its three major competitors have all gone through bankruptcy proceedings in the
past 20 years, Southwest has turned an annual profit every year since 1973, its third year of
operations. 7 At the end of 2019, the company was stronger than other majors on nearly every major
financial metric (table below). The company carried much lower leverage and solvency ratios than
each of its competitors. It also had very little in pension liabilities, unlike legacy carriers who were
saddled with obligations from challenging union negotiations. As a result, the company delivered
the highest returns on capital of the group, and it was the only one of the four with an Altman Z-
Score in the “healthy” range.

Then in March of 2020, the COVID-19 pandemic hit and the situation changed dramatically for
the airline industry. CFO Tammy Romo was going to have a very busy spring.

4
Rivkin and Therivel, “Delta Air Lines (A): The Low-Cost Carrier Threat,” p. 5.
5
Jeff Thomson, “Company Culture Soars at Southwest Airlines,” Forbes Magazine, December 18, 2018,
https://www.forbes.com/sites/jeffthomson/2018/12/18/company-culture-soars-at-southwest-airlines/#1a6a9a39615f
6
Ghim-Lay Yeo, “OBITUARY: Herb Kelleher, Low-Cost Airline Pioneer,” FlightGlobal, January 4, 2019,
https://www.flightglobal.com/obituary-herb-kelleher-low-cost-airline-pioneer/130872.article.
7
Source: Compustat

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 Southwest Airlines Co.: Credit Analysis and Financial Flexibility

Overview: In this case we analyze a firm from a credit perspective (think: banker, debt provider,
or credit analyst). From this perspective, we are trying to understand a firm’s “credit risk” – i.e.,
its ability to generate cash flows to pay principal and interest on a loan and its related “bankruptcy
risk” – i.e., the likelihood that the firm will become insolvent and potentially have to liquidate its
assets.
A credit perspective differs from an equity perspective in several ways. First, debtholders do not
share the same “upside” payoffs that shareholders have. If the firm performs well, debtholders still
only receive their contractual return (i.e., interest and principal); whereas equity holders receive
all the upside. Therefore, equity holders typically have incentives to increase firm risk, while
debtholders generally prefer the firm to have steady, predictable cash flows. Second, while equity
holders have no time horizon (i.e., no set period of time for them to receive a payoff), debt contracts
typically have a stated maturity date when the debt is ultimately due, suggesting more demand for
the firm to have more currently available cash flows relative to equity holders. Third, debtholders
may have “claims” to certain assets (i.e., collateral), such as inventory, receivables, or PP&E in
the event that the firm is unable to pay its debts; whereas, equity holders have no such direct asset
claims. Finally, in the event of liquidation, debtholders have priority (or preference) over equity
holders – i.e., they are paid before equity holders. There are yet other differences between debt
and equity (and various hybrid forms of debt further muddy the issue), but the basic differences in
payoffs, rights, and timeframes create differences in how this perspective changes the way a firm
is analyzed.
To study credit and bankruptcy risk, we will examine Southwest Airlines (ticker: LUV), one of
the four major airlines in the U.S. A unique aspect of this case is that we will examine Southwest
in two different operating environments: year 2017 to 2019, when airlines were generally
performing relatively well; and the first half of 2020 when COVID-19 had massive impacts on
travel.

Learning Objectives: After completing this assignment you should better be able to:
1. Understand how to calculate and use the canonical financial analysis ratios used in credit
analysis.
2. Assess the credit and bankruptcy risk of a firm.
3. Consider how firms employ tools of financial flexibility when facing a severe cash shock.
4. Learn how to acquire and use data from one of the major data platforms, Capital IQ.

Materials: In addition to this case document, this assignment includes four additional files:
1. Southwest’s 2019 Annual Report.
2. “Southwest- Assignment.xls” spreadsheet.
3. Southwest Q2 Earnings conference call transcript.
4. Southwest’s June 30, 2020 10-Q (quarterly report).

For this case, in addition to using the reports provided by Southwest Airlines, we will be using
reports provided by S&P’s Capital IQ. The purpose of this is to give you experience using one of
the major data providers which you may use in the “real world,” in addition to helping you learn

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 Southwest Airlines Co.: Credit Analysis and Financial Flexibility

how to assess the credit risk of a firm. As a student at Booth, you have access to Capital IQ from
the Intranet. Once you are logged into https://intranet.chicagobooth.edu, hover over “Teaching &
Research” and then click on “A-Z Career Research Databases.” Click on the Capital IQ link. To
access an individual company’s data, simply type the company name in the Capital IQ search bar.
I encourage you to play around in this database – there is a wealth of information to be found there.

Directions: After downloading the materials related to this case, read the background about
Southwest Airlines below and review the definitions for various ratios (provided in the spreadsheet
and discussed in the textbook). Then answer the case questions below. You will have two
documents to submit to Canvas:
1. Your brief responses to each of the questions below (simply write your responses to each
numbered question in a separate document and submit).
2. Your completed “Southwest – Assignment.xls” spreadsheet.

Case Questions

Part I: Credit ratio calculations and analysis

Part I.A: Ratio Calculations

The first step is to calculate financial ratios typically examined for credit risk analysis.

1) Open the Southwest.xls spreadsheet and calculate each of the ratios provided on the
“Definitions” tab. Southwest’s financial statements have been provided in the last three
tabs of the spreadsheet. These ratios are partitioned into three broad categories: Short-term
liquidity risk (ability of the firm to settle currently liabilities with current assets), Long-
term solvency risk (ability of the firm to settle all liabilities with all assets), and Coverage
ratios (ability of the firm to service its debts with the flows from operations). (Note: Chapter
5 of the Lundholm and Sloan textbook provides a discussion of these ratios.) Input your
calculations into the orange boxes on the “Definitions” tab. It is important to note that,
while there are “standard definitions” of ratios, they are not always calculated the same
way (or even should be calculated the same way). I have written some notes next to the
ratios to comment on how CapitalIQ calculates the ratios and how they might be done
differently.

2) Academics and practitioners alike (often working together) have developed a variety of
different models to estimate the bankruptcy risk of a firm. Many of the latest “cutting edge”
models are proprietary, and thus the factors considered in these models are kept
confidential. However, the first bankruptcy prediction model – the Altman Z-score,
attributed to Altman (1968) – remains a commonly used and reported metric. It combines
five different factors to derive a “bankruptcy score.” See this discussion about the Altman
Z-score provided by the Corporate Finance Institute:

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 Southwest Airlines Co.: Credit Analysis and Financial Flexibility

https://corporatefinanceinstitute.com/resources/knowledge/credit/altmans-z-score-model/.

Calculate Southwest’s Z-score for 2019 “Definitions” tab of the “Southwest Summary.xls”
spreadsheet to. You will need to know the market capitalization for Southwest as of the
end of 2019. The ending price per share is $53.98 and the number of shares outstanding as
of year-end is 519,064,316. (Note: the variables used in the Altman Z-Score model are
typically not averages, but rather measured at the point-of-time when the Z-Score is
calculated – e.g., December 31, 2019).

Part I.B: Ratio Analysis

For the remainder of this section, we will use the data and financial ratios provided by S&P’s
Capital IQ dataset. I have summarized the ratios for Southwest and its three major competitors in
the “Southwest Summary.xls” spreadsheet.

3) Compare your ratio calculations from Part I.A (which you completed in the “Definitions”
tab) to those reported on the Capital IQ portal for Southwest in 2019. After logging into
Capital IQ, pull up data for Southwest and then click on “Ratios” from the menu on the left
hand side of the screen. Again, I strongly encourage you to “play” with the Capital IQ
interface and connect the dots between the ratios reported and the underlying financial
information by clicking on the ratios. How do they define ratios and variables? Where do
they pull this information? If you click on a ratio, a pop-up window will define it and
specify the numerator and denominator. Whenever you use a data aggregator such as
CapitalIQ, it is useful to know how they use and manipulate the data. Do you note any
differences between the way you calculated the ratios based on Southwest’s financial
statements and how Capital IQ calculated the ratios? For example, one difference you
should note is in the calculation of the Z-Score. What is the primary difference (though
even this difference does not make a substantial impact on the score)?

4) Go to the “Annual Summary” tab of the “Southwest Summary.xls” spreadsheet. I have

copied the ratios for the years 2017-2019 for the four major airlines and reproduced the
Altman Z-Score calculations for each. Compare Southwest to its competitors in each of the
four sections and briefly describe what you see. Broadly: Which airline has been
performing the best? What factors appear to drive this performance? Which airline appears
to be best “setup” for the COVID crisis – e.g., which have more liquidity on hand and
which are more highly levered?

a. Short-Term Liquidity: Note that all the airlines have current ratios less than 1. Why?
Is this good or bad? Hint: What are the biggest current liabilities that airlines have?

b. Long-Term Solvency: Which airlines are more highly levered? In assessing

leverage, Southwest really stands out from the other airlines in the first four metrics
and less so with the “total liabilities to total assets.” Why? What makes up a bigger

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 Southwest Airlines Co.: Credit Analysis and Financial Flexibility

portion of Southwest’s capital structure? How would you feel if you were a lender
to any of these airlines? Which appears to be a better credit risk based solely on
these leverage ratios and why?

c. Coverage: Again, assess these ratios across the airlines. Which airline appears to
be most in trouble heading into COVID at the end of 2019 in terms of debt capacity
(i.e., which is most currently levered)? Also, note that the first three measures in
the coverage section are slightly different iterations of the numerator. What are the
differences between them (what do they include/exclude from the others)? Why are
these different measures potentially useful? Why are measures (1) and (3) quite
different for Southwest but not for Delta?

d. Z-Score: Southwest clearly has a better Z-Score than the other three carriers. Why?
Which two factors seem to be driving this difference?

5) You should see that both Delta’s and United’s debt-to-equity ratios jumped substantially
in 2018, while Southwest’s jumped a bit in 2019. (Consistent with Delta and United,
American’s debt also jumped substantially in 2018, but because it has a negative equity
position, Capital IQ reports the ratio as “Not Meaningful.”) What are these “jumps” in debt
related to? Why do the jumps happen at different points in time? What happened in 2018
for AAL, DAL, and UAL, which did not occur until 2019 for LUV? Moreover, when the
increase does occur for LUV in 2019, why is the increase less than the other three major
carriers? [Hint: This is an accounting choice issue.]

Part II: Analyzing financial flexibility.

Oftentimes in credit analysis, annual reports are not sufficiently timely. This is particularly true
when a firm faces a cash flow shock. The COVID-19 pandemic is an example of a massive shock
which substantially reduced airline traffic and caused immense financial strain on the airline
industry. To easily see just how much strain this caused, go to Southwest’s Income Statement tab
in Capital IQ and change the “Period Type” from “Annual” to “Quarterly” and click “Go.” You
will immediately note that while revenues declined in Q1 of 2020, the decline was much sharper
in Q2. In fact, Southwest’s COGS exceeded its revenues in Q2. In the face of such revenue
declines, both management and credits need to assess a firm’s “financial flexibility” – its ability
to focus on preserving and generating cash. Answer the following questions regarding Southwest
during the first half of 2020:

6) Looking at the income statement, COVID-19 clearly had a negative impact on Southwest’s
revenues. However, look at their balance sheet – what actually happened to their cash
balance?

7) From your answer to the previous question, you should have seen that Southwest generated
substantial financial flexibility, particularly in the 2nd quarter (i.e., its cash balance

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 Southwest Airlines Co.: Credit Analysis and Financial Flexibility

substantially increased). How did they do this? To answer this question, it is useful to
consider the most valuable financial statement when considering financial flexibility: the
statement of cash flows. Firms have options to generate cash in each of the three sections
of the statement of cash flows (operating, investing, and financing). Go through each of
these three sections for Q2 2020 – you will note that in a departure from Southwest’s typical
quarter, it generated positive cash flow in all three of these sections. Discuss what they did
in each section. How did they generate positive cash flows, on net? After looking at the
statement of cash flows and noting what appeared to change, go to the Q2 Earnings
conference call transcript. Pay particular attention to the comments of Tammy Romo,
Executive VP and Chief Financial Officer of Southwest starting on page 9. It will also be
helpful to examine the June 30 10-Q filed by Southwest. Discuss what Southwest did to
enhance financial flexibility in each of the sections below (while there is a lot of content
you could review for this, keep your responses brief – simply list the set of things you
found that Southwest did):

a. Cash from operations: Consider both expense and working capital items. How did
the company save on expenses? What did it do to preserve cash in working capital
accounts (i.e., increase current liabilities and reduce non-cash current assets)?

b. Cash from investing: Consider capital expenditures and other types of maneuvering
in this section.

c. Cash from financing: What were all the sources of cash Southwest received in this
section of the cash flow statement?

8) In Ms. Romo’s discussion in the conference call transcript, she mentions at least two
additional sources of financing/capital Southwest could tap into when needed. What are
these resources (see page 11 of the transcript)?

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