Analysis of Pan American World Airways, Inc. －Financial Analysis for Business Decision Using Beaver & Altman Studies－: 沖縄地域学リポジトリ

Title

Analysis of Pan American World Airways, Inc. −Financial

Analysis for Business Decision Using Beaver & Altman

Studies−

Author(s)

Miyamori, Masaki

Citation

沖縄短大論叢 = OKINAWA TANDAI RONSO, 6(1): 35-58

Issue Date

1992-03-31

URL

http://hdl.handle.net/20.500.12001/10632

Analysis of Pan American World Airways, Inc.

-- Financial

Analysis for Business

Decision

Using Beaver

&

Altman Studies

--Masaki Miyamori

TABLE OF CONTENTS

I . INTRODUCTION

n.

METHODOLOGY FOR ANALYSIS

m.

THE BEAVER STUDY

N.

THE ALTMAN STUDY

v.

FINAL ANALYSIS

VI. CONCLUSION

w.

APPENDIX

BIBLIOGROPHY

INTRODUCTION

This paper introduces Pan American World Airways. inc.

The main purpose of the paper is to analyze the company's present poor financial position, and to find its problems using the Beaver and Altman studies. The industry average ratios are also used to evaluate Pan am's weaknesses and strenths.

History and General Description

Pan American Airways was incorporated in New York on March 14, 1927. In January 1950, the company adopted its present name, Pan American World Airways, Inc. (12.p2)

Pan Am's principal business is the transportation of persons, property and mail by air. (12.p1) Its air transport operations are world-wide and extend to all poulated continents of the world. As of 1981 Pan Am owned 97 operating fleets and leased 30 for a total of 127, in

order to serve its vast array of customers. "Pan Am's subsidiary company. Pan Am World Services. Inc. provides management and technical services for government and commercial projects both in the United States and in

foreign countries." (12.p1)

Recent Situation for the Transportation Industry

In 1976 and 1977 the air transprot industry was recovering from the deficits of 1975. Its net profit margin

became 3.6% in 1977 up from a negative value in '75, and other ratios also improved. (1.p251) The industry continued to grow at an accelerating pace in 1978 as its revenue per passenger miles flown in scheduled servie increased. Net profit margins, return on total networth, return on total assets, and debt to total asssets all improved as well .

(2.p251) During the year, operating expenses (labor and fuel) rose faster than revenues, but gains from equipment sales and investment tax credits contributed to another year of record profits for the industry. (2.p251)

In 1979, the industry was still doing well, but profit had been hit hard by skyrocketing fuel costs, and air line passenger traffic which had improved steadily since 1977, was beginning to decline. As a result, it is predicted that the future, revenue passenger mile gains are likely to proceed at a slow pace and even though fares have been increased, the increases have not offset the rising fuel costs and decline in passenger traffic quri ty enough to improve porfits. (3.p25)

The explosive rise in the cost of fuel continued in 1980. Air line fares also continued to rise, and the higher fares that were needed had an adverse impact on air travel during the year. The growth of passenger travel was slow because of the economic dounturn consequently, the industry did not have much increase in its financial ratios or profits. (4.p251)

1981. These were : Deregulation, fuel costs and recession. "In October 1978, the Deregulation Act became law, giving carriers unprecedented freedom to enter and exit markets."

(5.p251) The second shock was the increased price of fuel costs. Jet fuel prices jumped about 60% in 1979, 55% in 1980 and 30% in 1981. The third shock to hit the airlines since 1978 was the recession. In 1980. there was a 5.4% traffic decline (as measured in revenue passenger miles) and a 5% decline in 1981. (5.p251)

The air transport industry showed improvement in profitability in 1982. This was due mainly to lower fuel prices and labor costs and employing of highly productive air carriers. However, there were still some weaknesses in the industry. Low fares were hurting its profitability, and fixed costs were still very high. (6.p251)

In 1982. the industry had been improving; yet some troubles arose in 1983 and 84. Net profit margin is still negative, and the industry is taking a hard line stance with its employees. However, divident yields are improving and it is expected that profitability will return to the air transport industry in near future. (8.p251)

METHODOLOGY FOR ANALYSIS

In this paper, the Beaver (Financial Ratios as Predictors of Failure by William H. Beaver) and Altman

studies (Discriminant Analysis and Financial Ratios by

Edward I . Altman) are the main analysis tools to analyze Pan Am.

According to the Beaver study, there are five main ratios that can predict a firm's possible failure. These are; cash flow to total debt, net income to total assets, total debt to total assets, working capital to total assets and the current ratio. Pan Am's five ratios were compared with the same five ratios from nonfailed firms and failed firms. If Pan Am's ratios were similar to those of the failed firms, it could be inferred that Pan Am was likely to fail.

Discriminant analysis delineates between nonfailed and failed firms using a model consisting of five ratios. These five ratios are combined and objectively weighted so as to achieve maxmum classification accuracy. (14.p90) The Z-score model was applied to Pan Am's ratios and the results were analyzed. If Pan Am's Z-score was negative, it could classified as bankrupt.

Finally, industry average ratios and Pan Am's ratios were compared and trends in Pan Am's ratios were analyzed. Unusual circumstances were considered and problems were identified in order to reach a conclusion concerning Pan Am's financial situation.

THE BEAVER STUDY

In the Beaver study. there.are three ways to analyze companies' financial ratios as predictors of failure. These are profile analysis, dichotomous classification tests and analysis of likelifood ratios. This paper will deal mostly with the profile analysis since it is the most simple to use and can best be explained within the framework of a "cash flow" model. (27 .p79)

In order to form predictions regarding those 5 ratios selected for the profile analysis, four propositions can be used. "The first is the size of the reservoir itself. The larger the reservoir, the smaller the probability of failure. The second is the net liquid-asset flow from operation, which measures the net amount of liquid assets supplied to the reservoir by current operations. The larger the net liquid-asset flow from operations, the smaller the probability of failure. The third is the debt held by the firm and is one measure of the potential drain upon the resevoir. The larger the amount of debt held, the greater the pobability of failure. The fourth is fund expenditures for operations and is the amount of liquid assets drained from the reservoir by operating expenditures. The larger the fund expenditures for operations, the greater the probability of failure."

(27.p80)

Accordiing to the results of profile analysis comparison of mean values of nonfailed firms and failed

firms, (see Fig .1) "the ratio distributions of nonfailed firms are quite stable throughout the five years before failure. The ratios distribution of the failed firms exhibits a marked deteriration as failure approaches."

(27.p101)

"The cash flow to total debt ratio has the ability to correctly classify both failed and nonfailed firms to a much greater extent than would be possible through randam pridiction". (27 .p101) Pan Am's cash flow to total debt ratio was behaving just like that of failed firms for 5 years before failure. (see Fig. 1) The year 1981 was chosen as "one year prior to bankruptcy" because 1981 was one of the two worst years for Pan Am; the other was 1982. After 1982, the company showed improvement in its financial condition.

The net income to; total assets ratio of Pan Am was also behaving similarly to, but better than,. the same ratio for the failed firms. 1978 was good year for Pan Am, because its net income to total assets ratio at that time was much closer to that of nonfailed firms'. If Pan Am had continued this position, it would not have had its worst year in 1981.

Pan Am's total debt to total assets ratio was much worse than that of both failed and nonfailed companies. One good trend was that one year prior to failure, Pan Am's ratio did not exceed that of failed firms; Pan Am kept its ratio at the same level as in other years.

The working capital ratio and the current ratio were both in similer position. These were also worse than ratios of nonfailed and failed firms. Trends of these ratios were similer to those of failed firms.

The result of the profile analysis were that all 5 ratios indicated Pan Am's unfavorable financial situation and predicted that Pan Am would fail in 1981 or soon thereafter.

THE ALTMAN STUDY

In 1968 Altman utilized the original Z-score model which was a profile of five financial ratios. "The purpose of the model is to discriminate between a sample of bankrupt manufacturing firms and a matched sample of healthy firm." (14.p90)

"The Z-score model is

Z=0.012XI+0.014Xz+0.033X3+0.006X4+0.999Xs Where Z =overall score

X1=working capital

I

total assets Xz=retained earnings

I

total assets

X3=earning before interest

&

taxes

I

total assets X4=market value of equity

&

preferred

I

total

liabilities

Xs=sales

I

total asset."(29.p192)

When a firm has a score below 1. 81, it is classified as bankrupt ; when a firm has a score above 2.99. it is

classified as heal thy. When the score is between 1. 81 and 2. 99, it is in the grey area where misclassif ications are observed. The most efficient cutoff value for bankrupt -nonbankrupt assignment is 2.675.

Since between 1977 and 1981, Z-scores for Pan Am were below 1 . 81 this indicates a category of bankruptcy. (see Fig. 2) The range of Z -scores for Pan Am was between 1.1991 and 1. 7645. According to the Altman study, Pan Am should habve been bankrupt, since it was clearly in the area of bankrupt during those 5 years.

To determine the causes of the low Z-scores for Pan Am, it is useful to check in more detail the 5 ratios which were used to caluculate the Z-scores. There are three ratios that caused Pan Am's Z-scores to be low ; these are : The working capital to total assets ratio (X 1 ) , the market value of equity to total liabilities ratio (X~). and the sales to total assets ratio

(Xs).

The other two ratios, retained earnings to total assets (X :l ) and EBIT to total

assets (X , ) held relatively good positions compared to bankrupt firms in the same industry. (see Fig.3) The unusually low Z-score in 1979 was caused by the low scores of

X

.1 and

Xs.

FINAL ANYLYSIS

According to the Beaver and Altman studies, Pan Am should have failed in 1981 or shortly thereafter. However

Pan Am today is still alive and making profit in 1984. However, it is also true that Pan Am had problems for a long time, especially in 1981 and 1982.

Pan Am's problems arose during 1979 and 1980. During these years, the air transportation industry also had a difficult time. Increasing fuel and labor costs, the rescession, and deregulation all hurt the industry in general and Pan Am in particular. Many of Pan Am's ratios deteriorated; for example net profit · margin chenged from 5.39 in 1978 to 3.06 in 1979, earing power changed from 25.29 in 1978 to 15.41 in 1979. At the same time, the industry's ratios also decreased (see Fig.4) in fact, some were worse than Pan Am's.

It is clear that Pan Am had its lowest Z-score in 5 years during 1979. (see Fig.2) In 1979. Pam Am bought National Airlines. (3. p267) This caused the current ratio to decline to 0.64. reduction of 0.4 compared to 1978. Uses of funds in the statement of changes increased substantially because of the acqusitions.

In 1980, Pan Am sold its headquarters building for about $400 million to Metropolitan Life Insurance Co.

(22 .p25) Even though Pan Am gained some cash from selling its building, the year 1980 was still considerable concern, due to the high fuel costs, the recession. and the National acquision. Inability to raise fares was also problem for the company because of restrictions on air fares imposed by the Civil Aeronautics Board. (4.p251)

In 1981 and 82, Pan Am's ratios became incredibly low. The net profit margin, the EPS, the return on total net worth, the intrest coverage, and the earning power all became negative values. (see Fig.4) The decrease in a current assets from $1. 012, 368, 000 in 1980 to $726, 282, 000 in 1981 was astounding The main reasons for this unprofitability were slumping air traffic, higher fuel and labor costs, sizable interest expenses and limited other income. ( 5. p251)

In light of these developments, why did not Pan

Am

go bankrupt ? There is a good explanation for this, namely, the sales to total assets ratio, which is "one measure of management's capability in dealing with competitive conditions." (28.p52) Pan

Am

had sales to total assets lower than that of Altman's bankrupt firms, but higher than the industry average especially in 1981. (see Fig. 3) The working capital to total assets ratio was also lower than the Altman's average score but similar to the industry.

In 1984, Pan

Am

improved its financial situation, and increased profits showing improvement in many ratios. Pan

Am

is expected to outperform the market average through the coming year (8.p251)

Since Pan

Am

has survived, why did the Beaver and Altman studies fail to accurately predict the firm's plight? There are several reasons for this :

In the Altman study, the study was based on manufacturing firms. (14.p90) All data was collected from

industries different from Pan Am. If the industry is different, it is hard to gain valid results from the analysis (eg. current ratio in the air transportation industry tends to be lower than in other industries.) Secondly, sample data were gathered between 1946 and 1965. (14.p101) It is also difficult to adapt old data to the current situation to analyze bankurptcy. Past data cannot be used to accurately compare present bankruptcy situation. Thirdly, the asset size of sample firms was between $1 millions and $25 million. (14.p101) Since Pan Am had about $2,963 million in assets in 1981, the comparative results could be invalid here as well. Fourth, using the Altman study, bankruptcy prediction accuracy was not significantly better with lease capitalization, (14.p107) yet Pan Am uses lease capitalization extensively in its financial reports.

For the Beaver study: first, the data used to form the model were outdated (up to 1963). (27 .p80) Secondly, profile analysis is a convenient way to outline the general relationship between the failed and nonfailed firms but not good to accurately predict failure. (27 .p83) Thirdly, in order to be able to borrow money from financial institutions, many firms artificially overstate their ratios. (27p.101) Fourth "the ratios do not pridict failed and nonfailed firms with the same degree of success." (27.p102)

CONCLUSION

Pan Am did not go bankrupt as the Beaver and Altman studies predicted. The reason is that these studies were not applicable to Pan Am which exsists in the air transportation industry in 1980's. 1979, 80, 81 and 82 were bad years for not only Pan Am but also the industry. Many ratios showed that Pan Am's financial situation was behaving similarly to the industry's.

As a conclusion, if one examine Pan Am's financial situatuion alone, it appears that the firm may be on the verge of bankruptcy. However, i f one compares Pan Am' s financial situation to the industry as a whole, one will not reach the same conclusion, since the entire industry is in a similar financial condition. In fact, in 1984 Pan Am is predicted to fare slightly better than its competitors in the airline industry.

Cash Total debt Non-failed firms ~ 0.1 0. 4 0

:: K-

~.!

-0.2 -0.4 1 2 3 4 5 Pan Am 81 80 79 78 77 Net Income Total debt

---1 2 3 4 5 81 80 79 78 77

Beaver Study

1.0 0. 9 0. 8 0. 7 0. 6 0. 5 0. 4 0. 3 0.2 0.1 Total debt Total assets

w

... ·· ..

----1 2 3 4 5 81 80 79 78 77

Fig-1

0.5 0. 4 0. 3 0.2 0.1 0 -0.1 -0.2 Working Capital Total assets

----v

A/

1 2 3 4 5 81 80 79 77 81 4 3 2 1 Current ratio

~

....

00 "'d" bO I t..

~

1 2 3 4 5 81 80 79 78 77

Beaver Study

*

for Pan Am

1977 1978 1979 1980 1981

Cash flow 0.16 0. 09 0.04 0.04 -0. 18 Total debt Net income 0.024 0. 058 0.028 0. 024 -0.064 Total assets Total debt 0.81 0.68 0. 73 0. 76 0. 73 Total assets Working Capital 0.041 0.009 -0. 108 -0. 02 -0.06 Total assets Curtent ratio 1.184 l. 039 0.642 0. 940 0.805

*

COIIPUSTAT OUTPUT Table-1

Altman Z-score

for

Pan Am 5 . Z-score

I

--- 4.886~ :~~~~~~~~p~f 4 Non-Bankrupt area 3 ~---~ 2 1 0 ~---~~---. }

G~

a<M Bankrupt area Industry Z-sores - - - -0. 2599 Mean valve of Bankrupt - ] 77 78 79 80 81 YEAR

Fig-2

-50-Al

trnan

X-scores

(Pan am and Industry

aver e ge)

X 1 X 2 X 3 X 4 X 5

2.0

---40 _{Group mean for} 4 20 247. 7

---

_---·

non-bankrupt

---

---3 30 10 20 20 0 50 1.5

---·

I!) ... I 10 -10 40

---0 -20 ' -·--10

1'

-30

_---

1.0

---

-·-Group mean for

-20 Bunkrupt 10

77 78 79 80 81 77 78 79 80 81 77 78 79 80 81 77 78 79 80 81 77 78 79 80 81

Fig-3

*

Bankrupt

z

-0.2599 X1 -6.1 X2 -62.6 X3 -31.8 X4 40.1 X5 1.5X

Altman Study

Z-scores and X#s-scores for Pan

Am

"'

"'"'

**

**

Non-1 9 7 7 1978 1 9 7 9 Bankrupt 4.8863 1. 4837 1. 7645 1. 2728 41. 4 4.1 0. 9 -10.8 35.5 5. 99 11. 35 11.53 15.4 7. 56 10.35 5.62 247.7 16.07 29.66 21. 35 1.9X LOX 1.1X 0. 9X ·

**

1 9 8 0 1. 6644 -2.0 11. 55 7. 18 16.28 1.2X

*

(29. p193)

**

1 9 8 1 1. 1991 -6 12.49 -9.05 19.15 1.3X

Table-2

* *

COIPUSTAT OUTPUT

C'J

Altman Z-scores

( I n d u s t r y 1979-1981)* 1 9 7 9 1 9 8 0 1 9 8 1

z

1. 242

1.179

1.181

Xl

-2.8

-0.4

-7.4

X2

15.46

13.04

11.13

X3

0.09

-1.49

-1.96

X4

29.95

26.18

28~48 X5 0.8773 0. 8944 0. 9440

*

(29. Pl93)

-53-The ratios of Pan Am and the Industry

Current ratio Debt to total Assets

1.4 60 1.2 ₅₅ 1. 45 0.4 40 0.2 ₃₅ 77 78 79 80 81 82 77 78 79 80 81 82

Price earning ratio Return on total Networth 20 7 15 6 10 5 5 4 0 3 -5 2 -10 1 -15 77 78 79 80 81 82 77 78 79 80 81 82 F i g-4 (A)

-54-The ratios of Pan Am and the Industry

Net profit margin EPS

6 6 ' ' 5 5 4 4 3 3 2 _' 2 ' Industry ' 1 ' ₁ ' 0 ' _' 0

I

' ' ' -1 -1 77 78 79 80 81 82 77 78 79 80 81 82

Interest coverge Earning power

4 30 3 25 2 20 1 15 0 10 -1 5 -2 0 -3 -5 77 78 79 80 81 82 77 78 79 80 81 82 F i g-4 (B)

*

**

The ratios of Pan

Am

and the Industry

1 9 7 7 1 9 7 8 1 9 7 9

Current Pan Am 1. 18 1. 04 0. 64 ratio Industry 1. 17 1. 05 0. 93 Debt to Pan Am 60.65 45.03 41. 15 Total Assets Industry 53. 21 46. 10 51. 73 Net profit Pan Am 2. 36 5.39 3. 06 margin Industry 3. 3 4. 9 1.9 Earning per Pan Am 1. 06 2. 31 1. 07

Share Industry 6.56 11.11 4. 26 Price Earning Pan Am 4. 72 2. 81 5. 61 ratios Industry 5.87 4.57 10. 67 Return on Pan Am 12.5 18. 3 10.5

Total networth Industry 11. 9 16. 6 6. 8 Interest coverage Pan Am 1. 56 2. 53 2. 14

Earning Power Pan Am 22. 98 25.29 15. 41

Table-3 1980 0. 94 0. 86 49. 20 54. 90 2. 00 NA 1.13 0. 55 3. 72 68. 03 9. 96 NA 1. 67 6. 60

*

CUMPUSTAT OUTPUT

* *

00. P40) 1 9 81 1 9 8 2 0. 81 0. 64 0. 76 0. 81 41. 372 NA 54. 53 57.33 -6. 84 -13. 06 NA 0. 2 -3. 65 -1. 40 -2.50 -6. 75 NA NA NA NA -2.4 -14.6 NA 4.0 . -2.00 NA -5.32 NA <.0 L!) I

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18

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Mar 26.

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