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The Airline Industry Loses Altitude
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10108 |
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Section : |
CURRENT ISSUES
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| Issue
Date : |
4 / 1993 |
1,565 Words |
| Author
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Richard D. Gritta
Richard D. Gritta is professor of finance at the University of
Portland in Oregon. |
Deregulation, increases in fuel costs, fare wars, intense competitive pressures, and recessions, among other things, have all been blamed for the financial problems of the U.S. airline industry over the past two decades. While these factors have contributed to the industry's deterioration, the major cause of the problem lies in the method many carriers have employed to finance aircraft acquisitions. Most airlines floated far too much debt to finance the last three equipment cycles.
Starting with the first generation of jet aircraft in the early 1960s and '80s with the second and third generation--the wide body (B747s, DC10s) jets--carriers routinely opted for debt finance, in spite of the dangers that this posed for their long-run viability.
The situation reached its climax over the past decade. Major carriers, like Eastern and Pan American, went belly up. Airlines declared bankruptcy at an alarming rate, and today many continue to operate under court protection. Smaller carriers vanished as replacement upstarts struggled to find their niche. Today many of the larger carriers fare no better; caught in a web of debt they wove themselves. Mergers have been looked at as a solution, but the problem lies elsewhere: the industry's tendency to finance by debt.
To fully understand the dangers of debt finance in certain industries, such as air transportation, it is first necessary to briefly consider the three types of risks that affect all companies in our economy: business risk, financial risk, and total or combined risk.
Business risk is the volatility in operating profits (before interest and taxes) over time. This risk is caused by one factor, or by a combination of several factors. One such factor is the high levels of fixed costs (depreciation, etc.) in the firm's operating structure. Fixed costs operate much like a mechanical lever. Since they are constant, regardless of the level of revenues, fixed costs increase the variability of operating profits as revenues change. Another factor affecting business risk is the cyclical nature of demand in some industries. Firms prone to recessions have a higher business risk. Obviously, if revenues fluctuate with economic conditions, so do operating profits. Finally, this risk is significantly increased by competition, which results in more unstable pricing strategies and thus destabilizes operating profits. It is important to note that business risk is, for the most part, beyond management's control.
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