analysis of pan american world airways, inc. －financial...
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TitleAnalysis of Pan American World Airways, Inc. －FinancialAnalysis for Business Decision Using Beaver & AltmanStudies－
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
Rights 沖縄大学短期大学部
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
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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
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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)
There were three shocks during the period 1978 through
-37-
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
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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.
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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
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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.
-41-
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
-42-
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
-43-
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)
-44-
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
-45-
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)
-46-
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, if 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.
-47-
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
-49-
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 l!)
Altman Z-scores (Industry 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)
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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)
-55-
* ** 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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-57-
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