Chapter 9: Southwest Airlines: Analysis of Debt and Liabilities

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It's kind of wild when you think about how much money big companies borrow.

Oh yeah.

I mean, we're talking amounts that are bigger than some countries whole economies.

Right, like it's just staggering.

And one of the main ways they do this is through these things called long -term liabilities.

And today we are going deep on one of the most important ones,

bonds payable.

Yeah, these are like the building blocks for a company like Southwest Airlines.

Back in 2016, they were flying over a hundred million passengers.

Oh wow.

Yeah, huge operation.

And think about the cost of all those planes and airports.

Right, like how do you even pay for all that?

Exactly.

It's rarely just straight cash bonds are a big part of the picture.

So today we're going to unpack all that so you can really understand how these long -term IOUs work and why they're so important.

Yeah, we want to give you a solid grasp of how to account for bonds and the interest they pay using both straight line amortization and the more complex effective interest method.

Yeah, and we'll also get into some of the other quirks that bonds can have.

Right, like the different types and stuff.

Exactly, and then we'll look at other kinds of long -term obligations beyond just bonds and see how all this borrowing affects a company's financial picture.

Of course, we'll break down how these liabilities show up on the financial statements so you can spot them yourself.

Okay, so first things first, let's define what bonds payable actually are.

Okay, so imagine instead of going to a bank and getting one big loan,

a company like Southwest goes out to a bunch of different investors.

Oh, okay, so it's like they're spreading it out.

Exactly, they're essentially creating a whole bunch of smaller IOUs, and these are the bond certificates.

Each one is held by a bondholder, and each certificate states the principal, which is also called the face value or par value, and that's the amount that the company promises to pay back.

On a specific date, right?

Right, on the maturity date.

Okay, so that's the principal, but of course there's a cost for using all that money, the interest.

Right, exactly, the bond certificate will also say what the stated interest rate is, and that's often called the coupon rate.

And this determines how much cash the company will pay to the bondholders, and usually that's twice a year.

Yeah, so it's like a regular payment.

Yeah, it's like rent for the money.

Okay, that makes sense.

Now, it's also good to know how these bonds actually get out into the market.

Usually companies work with an underwriter.

Oh, like a middleman?

Yeah, exactly.

It's a financial firm like JP Morgan Chase or Bank of America, and they basically buy the bonds from the company and then sell them to their clients.

Okay, and they take a cut for doing that.

Right, they take a commission so the company doesn't get the full face value upfront because of those fees.

Okay, that's interesting.

So let's get into the accounting side of things.

What happens when bonds are issued at their face value, the par value?

So that happens when the interest rate the company is offering on the bond is the same as what the market expects for bonds with similar risk.

Okay, so it's like supply and demand or balance.

Exactly, no premium, no discount.

Okay, so back to our Southwest example.

Let's say they issue $100 ,000 worth of 9 % bonds that mature in five years, and they issue them at par on January 1st, 2018.

How does the accounting look there?

So it's pretty simple.

They would record a $100 ,000 increase in their cash account, that's the money coming in, and then a corresponding $100 ,000 increase in their bonds payable account to show the new liability.

Okay, so both sides of the balance sheet grow.

Exactly now, because those bonds have a 9 % annual interest rate.

Southwest will make payments twice a year.

So that means for each six -month period, from January 1 to July 1, and then July 1 to December 31,

the cash payment will be $100 ,000 times 9%, and then times six months out of 12, which comes out to $4 ,500.

Okay, so when they make that first payment on July 1st, 2018,

they decrease their cash by $4 ,500 and increase their interest expense by the same amount.

So that shows the money going out and the cost of borrowing.

Exactly.

And the bonds payable account stays at $100 ,000, so it doesn't change.

Got it.

And this $4 ,500 payment keeps going for the whole five years.

Yep, twice a year every year.

Okay, and at the end of each year, if the payment hasn't happened right at year end, they would accrue the interest expense for that partial period.

Right, just to make sure everything's recorded properly.

Okay, and then finally on January 1st, 2023,

the bonds mature.

So Southwest pays back the original $100 ,000.

Right.

And they decrease bonds payable by $100 ,000 and decrease cash by the same amount.

So the liability is gone from their books.

Okay, so that's the ideal case.

Bonds at par,

but what about when the market doesn't agree with the interest rate the company is offering?

Right.

That's when we get into bonds issued at a discount.

Okay, so tell me about that.

A discount happens when the market interest rate, which is what investors can get on other similar bonds,

is higher than the interest rate on the bond certificate.

Okay, so if Southwest is offering 9%, but the market wants 10%.

Exactly, then Southwest bonds look less appealing.

So investors will only buy them at a price lower than the face value to make up for that difference.

So they're basically paying less upfront to get a better return.

Exactly, and the difference between that $100 ,000 face value and the lower price they actually sell for is the discount.

Okay, so let's go back to Southwest.

Suppose they still want to issue $100 ,000 of 9 % five -year bonds, but now the market wants 10%.

So they have to sell those bonds for less than $100 ,000.

Our source mentioned a price of $96 ,150.

That means they only get $96 ,150 in cash.

Right, because $100 ,000 times .9615 is $96 ,150.

Okay, and how does that get recorded?

So cash goes up by the $96 ,150 they received, and that's a debit.

Bonds payable still goes up by the face value of $100 ,000, and that's a credit.

And then the difference is $3 ,850 goes into an account called discount on bonds payable, and that's a debit too.

Okay, discount on bonds payable, so what exactly is that?

So that's what we call a contra liability account.

It's kind of like a negative balance attached to the bonds payable.

It shows that Southwest didn't actually get the full $100 ,000 upfront, so the real amount they go with at the start is less than the face value, and it has a debit balance, which is unusual for liability.

Okay, I see.

So even though the bonds payable account says $100 ,000, the actual liability is only $96 ,150.

Exactly, that's the carrying value.

Now remember, the cash interest payment is still fixed at $4 ,500 based on that stated rate.

Right.

But over the life of these bonds,

Southwest's total interest expense has to reflect the fact that they borrowed less than $100 ,000, but have to pay back the full amount at maturity.

So that $3 ,850 discount isn't just a one -time thing.

Right, it's an extra cost of borrowing that needs to be recognized over those five years, and that's called amortization.

Okay, and one way to do that is the straight line method, right?

Exactly.

The straight line method is pretty simple.

You take that total discount, the $3 ,850, and spread it out evenly over the life of the bond based on the number of interest payments.

Okay.

So we have a five -year bond with payments twice a year, so that's 10 periods.

Right.

So you divide the $3 ,850 by 10, and you get $385 of discount amortization for each payment.

Okay, so every six months, Southwest would record $4 ,500 for the actual cash payment, and another $385 for the discount amortization.

That's right.

So the total interest expense they report is $4 ,885.

Okay, and how does that look in the journal entry?

So on July 4, 2018, you would debit interest expense for that $4 ,885, then credit cash for the $4 ,500 they actually paid, and then credit discount on bonds payable for the $385.

Okay, and that credit to the discount account reduces its balance, right?

Exactly.

Over time, as we keep doing this with each payment, that discount will shrink, and the carrying value of the bond will go up until it hits the full $100 ,000 of maturity.

Got it.

So with a discount, the company's actual cost of borrowing is higher than what's stated on the bond.

Right, because of that amortization.

Now, let's switch gears.

What happens when bonds are issued at a premium?

Okay, so a premium happens when the interest rate on the bonds is higher than the market rate.

So Southwest is offering 9%, but the market only wants 8%.

Exactly.

Their bonds look really good now.

So investors will pay more than the $100 ,000 face value to get them.

And that extra amount above the face value is the premium.

Okay, so in our hypothetical Southwest case, let's say they issue $100 ,000 of those 9 % five -year bonds, and the market rate is only 8%.

They could issue them at, let's say, $103 .85, meaning they receive $103 ,850 in cash.

Right, so now the carrying value of the bond is $103 ,850.

That's the $100 ,000 face value plus a $3 ,850 premium.

Okay, and is premium on bonds payable also a contra account?

Nope, this one is a regular liability account with a credit balance.

Okay, and does this premium also get amortized?

Yes, it does, and it reduces the interest expense each period.

So it's the opposite of the discount.

Exactly.

Instead of adding to the interest expense, we subtract from it.

Okay, that makes sense.

Now we've covered the basics of issuing bonds at par, at a discount, and at a premium.

Right, and you mentioned earlier that there are two ways to deal with these discounts and premiums straight line, which we just talked about, and the effective interest amortization method.

Why do we have two, and when do we use each one?

So GAAP generally prefers the effective interest method.

GAAP being generally accepted accounting principles.

Right, it's considered to be more accurate because it factors in the time value of money.

But GAAP does allow you to use the straight line method if the results aren't too different from what you would get with the effective interest method.

So if the discount or premium is small, companies might choose to keep it simple and use straight line.

Exactly.

It's all about materiality.

Okay, so how is the interest expense calculated differently under the effective interest method?

So the key difference is that the interest expense won't be the same fixed amount every time unlike with straight line.

Okay.

You have to look at the market interest rate at the time the bonds were issued and multiply that by the carrying value of the bond at the beginning of each period.

Okay, so it's a bit more dynamic.

Right, and the difference between that calculated interest expense and the fixed cash payment based on the stated rate is the amount of discount or premium amortization for that period.

Okay, so it's kind of like recalculating every time.

Exactly, you're taking into account how the carrying value changes.

Okay, so once you have that initial price and the market rate, how do you keep track of everything?

The best way is to use an amortization table.

Okay, what's that?

It's basically a table that shows all the important information for each payment date.

Okay.

So you have the date, the fixed cash payment, the interest expense calculated using that market rate, the amount of discount or premium that's being amortized, the remaining balance of the discount or premium, and the carrying value at the end of the period.

Okay, so it's a way to see how that discount or premium gets reduced to zero over time.

Exactly, it shows the whole process.

Okay, so let's go back to our Southwest discount bond example.

$100 ,000 face value, 9 % stated rate, five -year term, and a 10 % annual market rate, which is 5 % every six months.

We said the issue price was $96 ,149,

and the total discount was $3 ,851.

So if we look at exhibit nine to two in our source, we can see the first row of the amortization table.

The cash payment is still $4 ,500, but the interest expense is calculated as 5 % times that initial carrying value of $96 ,149, which comes out to about $4 ,807.

Exactly, and the difference between that $4 ,807 expense and the $4 ,500 payment is the discount amortization, which is $3 ,707.

Okay, so that reduces the discount balance and the carrying value goes up.

So the journal entry for that first six months using the effective interest method would be a debit to interest expense for $4 ,807,

a credit to cash for the $4 ,500, and a credit to discount on bonds payable for the $307.

Exactly, and this keeps going over the life of the bond with the interest expense changing a little each time as the carrying value increases.

And by the time the bond matures, that initial $3 ,851 discount will be gone, and the carrying value will be back to $100 ,000.

Got it.

And exhibit nine to three shows how the interest expense goes up over time with a discount bond.

Right.

It's a nice visual.

Okay.

Now let's look at the premium example again.

Southwest issued those 9 % bonds at $104 ,100 because the market rate was 8 % annually or 4 % every six months, giving us a premium of $4 ,100.

Right.

Exhibit nine to five shows the amortization table for a premium bond.

What's the main difference we see here?

So the cash payment is still $4 ,500, but now the interest expense is calculated as 4 % times that initial carrying value of $104 ,100, which comes out to $4 ,164.

So now the cash payment is actually higher than the calculated expense.

And that difference of 336 handlers at the premium amortization.

Right.

It reduces the premium balance and the carrying value goes down.

Okay.

So the journal entry here would be a debit to interest expense for $4 ,164,

a debit to

payable for $336 and a credit to cash for $4 ,500.

That's it.

And exhibit nine to six shows how the interest expense goes down over the life of a premium bond while exhibit nine to seven shows the carrying value going down until it reaches $100 ,000 at maturity.

Right.

It's the mirror image of the discount bond.

And I'm guessing if a company's year end happens between interest payments, they would accrue the expense and amortization up to that point.

Exactly.

Using the effective interest method and our source mentions Alphabet Inc.

as an example.

Okay.

So we've covered a lot about how to account for bonds, but they can also have other features.

Oh, yeah.

There are a few bells and whistles.

What are some of the common ones we should know about?

Two big ones are callable bonds and convertible bonds or notes.

Callable bonds give the company the right to pay off the bonds early before the maturity date.

Oh, interesting.

So they can kind of refinance.

Exactly.

They usually have to pay a bit more than the face value, but it can be a good deal if interest rates have gone down since they issued the bonds.

Okay.

What about convertible bonds?

So convertible bonds give the bondholder the option to convert their bonds into shares of the company's stock.

Oh, so it's like a two for one.

Right.

They get the security of a bond with the potential upside of the stock.

Okay.

So why would a company issue these?

Well, because of that added potential for investors, companies can offer a lower interest rate on convertible bonds.

Oh, okay.

So it's a trade off.

Exactly.

And if the stock does well, bondholders are likely to convert, which reduces the company's debt and increases its equity.

Okay.

So we've focused a lot on bonds, but Southwest has other long term liabilities too.

Right.

Most big companies do.

What are some of the key ones we should be aware of?

So you look at their financials and the footnotes, you'll see a few important categories.

One is deferred income taxes.

Okay.

What are those?

So deferred income taxes come up because the rules for recognizing revenues and expenses for GAAP are different from the rules for taxes.

So for example, a company might use straight line depreciation for their financials, but an accelerated method like MCRS for taxes.

And that creates differences between the income tax expense they report and the actual taxes they pay in a given year.

And how does that become a liability?

So if the book value of an asset is higher for GAAP than for taxes, it means the company will have lower taxable income now, but higher taxable income later.

And that future tax obligation is a deferred tax liability.

Okay, that makes sense.

R -Source uses Southwest's fleet of 30 planes as an example.

If the book value of those planes is higher for accounting than for taxes, it creates a future liability.

So the journal entry would include not just the current taxes payable, but also an increase in this long term deferred tax liability.

That's deferred income taxes.

What else do we have?

Another important category is commitments.

These are basically promises a company has made that will create future obligations.

Okay, like what?

Southwest has agreements with cities for airport construction, for example.

So the city might pay for the project up front,

and Southwest would record those costs as assets constructed for others on their balance sheet.

Then as they get reimbursed by the city, they reduce that asset and increase a long term liability called construction obligation.

And they had a big balance in that account as of December 31st, 2016.

Right, because of all those airport projects.

Okay, and finally, let's talk about leases.

We hear a lot about companies leasing things instead of buying them.

Yeah, leasing is really common.

It lets companies use assets without having to pay a huge amount up front.

Right, like with those airplanes.

Exactly, and historically there were two main types of leases.

Finance leases and operating leases.

Finance leases were basically treated as if the company had bought the asset with debt.

Like if ownership transferred at the end of the lease or the lease term was most of the asset's life, but operating leases were more like rentals.

And how did the accounting differ for those?

The big difference was that operating leases didn't show up on the balance sheet as liabilities.

Really?

Yeah, the payments were mostly expensed as rent, and the future obligations were just in the footnotes.

Oh, so it was like hidden debt.

Yeah, kind of like off balance sheet financing.

But then FASB came out with a new standard in 2016 that changed things.

Okay, what happened?

Now both finance and operating leases, longer than 12 months, have to be on the balance sheet.

Oh wow, so everything's out in the open now.

Right, it gives a much clearer picture of a company's leverage.

So how does that new rule work?

Companies now have to capitalize those operating leases.

They record a right of use asset for their right to use the asset, and a lease liability for the future payments.

Okay, so both sides of the balance sheet go up.

Exactly, and that can affect ratios like the debt ratio and return on assets.

Right, it makes the company look more leveraged.

Right, our source gives examples of how this would have changed things for Southwest and Walgreens.

Okay, so this all ties back to analyzing a company's financial health.

We've talked about the debt ratio, but what other tools are there to assess a company's borrowing?

Another important one is the leverage ratio, sometimes called the equity multiplier.

Okay, how do you calculate that?

You take the company's average total assets and divide it by their average common stockholders' equity.

Okay, and what does that tell you?

It tells you how many dollars of assets the company has for every dollar of equity from its owners.

Okay.

So a ratio of 1 .0 means they have no debt.

All their assets are funded by equity.

Okay.

And the higher the ratio, the more they're relying on debt.

So how does leverage affect profitability for shareholders?

Leverage can be good or bad for the return on stockholders' equity, or ROE.

Okay.

If a company is profitable, using debt can actually make their ROE even higher.

Oh, interesting.

How does that work?

Because they're using borrowed money at a fixed interest rate to generate profits that go to the equity holders.

So it's like amplifying the returns.

Exactly.

But the flip side is that if a company has losses, leverage will make those losses even worse.

Oh, so it's risky.

It's a double -edged sword.

And the leverage ratio is actually a key part of the DuPont analysis, which is a framework for breaking down ROE.

Okay.

If that makes sense.

Our source compared Southwest and United Continental's leverage and debt ratios back in 2016.

What did they find?

So in 2016, Southwest had a leverage ratio of 2 .82 and a debt ratio of 63 .8 percent, while United Continental had a leverage ratio of 4 .61 and a debt ratio of 78 .5 percent.

Okay.

So what does that mean?

It means that Southwest was using less debt than United to finance its assets.

So they were more conservative.

Exactly.

Now there's another ratio mentioned, the times interest earned ratio.

Right.

That one tells us about a company's ability to handle its debt.

How so?

You take the company's operating income and divide it by their interest expense.

Okay.

This tells you how easily they can cover their interest payments with the money they make from their regular business.

Okay.

So a higher ratio is better.

Exactly.

It means they have more cushion and are less likely to have problems making those debt payments.

So how did Southwest and United compare on this one?

Southwest was in a much better position.

Their ratio was 30 .8 times in 2016.

Wow.

So their income was almost 31 times greater than their interest expense.

Yeah.

They were doing really well.

United's ratio was 7 .1 times, which is still decent, but much lower than Southwest.

Right.

So they had less room for error.

Exactly.

Okay.

So last but not least, let's talk about where all these long -term liabilities show up in a company's reports.

Okay.

So if you look at Southwest's balance sheet, as of December 30th versus 2016, you'll see a section for long -term liabilities usually below the current liabilities.

Okay.

What kind of things are listed there?

You'll see things like long -term debt,

less current maturities, which is the debt that's not due within the next year, and then you'll also see deferred income taxes,

construction obligation from those airport projects, and maybe a category called other noncurrent liabilities for other stuff.

Okay.

And what about the long -term debt itself?

What's included in that?

That can include different kinds of borrowing, like term loans from banks, pass -through certificates, fixed rate notes for airplanes, general debentures, and obligations from finance leases.

Okay.

So it's a mix of things.

And when we see the balance for long -term debt, is that always the exact face value of the bond?

Not necessarily.

The balance sheet usually shows the carrying amount.

Right.

So that's the face value adjusted for any discount or premium?

Exactly.

And also any costs they had when issuing the bonds.

Okay.

Now it's important to note that the fair value of the debt, which is what it would be worth on the market, can sometimes be different from that carrying amount.

Okay.

And that was the case for Southwest in 2016, right?

Yeah.

And companies usually disclose that fair value in the footnotes.

Okay.

That's good to know.

And what about the statement of cash flows?

Where did these liabilities show up there?

So on the cash flow statement, anything to do with debt is in the financing activity section.

You'll see cash coming in from issuing new debt, like when Southwest issues new bonds.

And you'll see cash going out to repay principal on existing debt and for payments on capital leases.

So if you look at Southwest's cash flow statement for 2016, you'll see both of those flows.

So it shows how the company is actually managing its debt.

Exactly.

It's a good way to see the big picture.

All right.

So we've covered a lot of ground today about long -term liabilities and especially bonds Yeah.

It's been a deep dive.

And it's clear that these are really important tools for companies to finance their operations and grow.

Absolutely.

We've gone through how bonds are valued at the start, whether they're at par, at a discount or at a premium, and then how to amortize those differences over time with the straight line method or the effective interest method.

And we talked about other types of long -term obligations like deferred taxes commitments and leases and how the rules for leases have changed.

And then we looked at leverage ratios, which are crucial for understanding a company's financial risk.

Yeah.

They tell you a lot about how a company is using debt.

Exactly.

So as you, our listener, think about all the ways companies finance themselves,

what do you think are the most important things for investors to look at when they're evaluating a company's debt and its ability to handle its obligations in the long run?

It's a really important question and something to keep in mind as you continue to explore company financials and stay informed.

Yeah.

There's always more to learn.

Absolutely.

And that's it for our deep dive today.

Thanks for joining us.

Thanks for having me.