Financial Performance of Low-Cost and Full-Service Airlines in Times of Crisis, The

Canadian Journal of Administrative Sciences, Mar 2005 by Flouris, Triant, Walker, Thomas John

The finance literature refers to the idea that news is quickly impounded in security prices as the "efficient market hypothesis," first described by Fama, Fisher, and Jensen (1969). The assumption that markets are efficient implies that security prices reflect all relevant information known to investors and thus provide us with the best estimate of a firm's future profitability. There is significant empirical support for the efficient market hypothesis, including the Carter and Simkins' (2004) study of airline stocks following 9/11. We add to Carter and Simkins' findings by focusing specifically on performance differences between low-cost and traditional-cost airlines. In addition, our study is the first to examine the accounting performance of airlines post-9/11, and to examine how 9/11 influenced the systematic and unsystematic volatility of their returns.

If we assume that markets are efficient, and therefore set rational prices, we can measure whether the corporate strategy of such a low-cost carrier as Southwest Airlines, post-9/11, was in the best interest of shareholders by comparing the firm's profitability and stock price performance in the months after 9/11 to the performance of other airlines that follow a full-service business model (Continental and Northwest).

Financial Ratio Analysis

To evaluate the accounting performance of our sample airlines we focus on examining some of the most frequently used financial ratios. Financial ratios can be grouped into four categories: (a) liquidity ratios, (b) activity ratios, (c) financing ratios, and (d) profitability ratios. Liquidity ratios provide measures of a company's ability to satisfy short-term obligations. Activity ratios measure a company's efficiency in managing its assets. Financing ratios provide some indication of the riskiness of a company with regard to paying its long-term debts. Finally, profitability ratios assist in evaluating various aspects of a company's profit making activities.

It is important to remember that when using financial ratios to assess the overall financial stability of a company, more than one ratio should be considered when formulating an accurate opinion. For example, a company's solvency ratios may be ideal, but if the ratios that help analyze profitability and activity are bad (profits are down and sales are stagnant), a much different opinion would be formulated.

Our comparison employs both a cross-sectional and time series analysis. Cross-sectional analysis consists of comparing the financial ratios of different firms in the same industry at the same point in time. Time-series analysis consists of comparing the firms' accounting performance ratios over time.

Tyran (1986), Lev (1994), and Gibson (1997) describe a plethora of financial ratios that fall under the aforementioned categories. For brevity, we only report those ratios here that we feel to be most insightful.14 The following outlines the calculation of each ratio and discusses its meaning.

Liquidity ratios: current ratio. The current ratio measures the ability of the firm to pay its current bills while still allowing for a safety margin above the required amount needed to pay current obligations. We calculate the current ratio as follows: