Gearing ratios

Table of Contents

1. EXECUTIVE SUMMARY

2. INTRODUCTION

3. RELATED THEORY

4. DATA ANALYSIS AND DISCUSSION

5. CONCLUSION

6. REFERENCES

7. APPENDICES

1. Executive summary

This report aims at analysing the gearing ratios of both easyJet PLC, a British airline operating in several countries, and Lufthansa AG, a German aviation company operating globally. easyJet is listed in the British stock index FTSE100 and Lufthansa is listed in the German stock index DAX. These companies have been chosen, because they belong to the continent’s biggest airlines and a direct comparison seems to be feasible. The gearing ratios have been calculated using data from the companies’ annual reports from 2015 onwards. The report found that easyJet has always had a lower gearing ratio than Lufthansa and consequently a more stable, less risky financial position. Moreover, the report found that the accounting policies of both companies are the same and thus the interpretation of results is not distorted. However, the report also found that the tone of easyJet’s narrative reporting is more optimistic, which is likely to influence the reader’s opinion in its favour. Limitations are the small sample size, the short time span and that only one ratio is analysed. Consequently, results cannot be generalised. Moreover, financial ratios do not provide a benchmark. That’s why an analysis of the industry average had been conducted as well.

2. Introduction

This report aims to examine easyJet’s financial performance using financial gearing ratios and comparisons with both competitor Lufthansa and the overall industry. Firstly, it describes gearing ratios and states how accounting policies and narrative information might influence the results. Secondly, it analyses and discusses the gearing ratios of both easyJet and Lufthansa considering the industry average. The source of information is predominantly the companies’ annual reports and Bloomberg.

3. Related theory

Both companies have faced challenges regarding “higher oil prices and increased compensation payouts for delays and cancellations caused by air controller shortages and strikes” (Spero, 2018). The gearing ratio analysis can provide information on how these increased expenses were financed, with equity or debt.

Financial gearing provides information about the source of long-term funds (Kumar & Rao, 2015) and consequently about the financial situation of a company (Elliott, 2019). It overlaps with operational gearing and income gearing (Figure 1), because a high amount of debt increases the company’s interest expenses and the proportion of annual pre-interest profits devoted to lenders (Araujo & Hambur, 2018).

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Figure 1: Types of gearing ratios (Araujo & Hambur, 2018)

Financial gearing could be considered the most relevant ratio for stakeholders, because it indicates the creditworthiness and financial risk associated with a company (Mishra, 2019). It is calculated as the proportion of a firm’s total long-term capital that is provided by creditors (see Appendix A).

A company that is heavily geared is more likely to fall into financial distress (Männasoo, Maripuu & Hazak, 2018), which would affect several stakeholders, such as employees, shareholders and suppliers. A high gearing ratio has been found to increase agency costs and consequently the risk of losing control over the company (Yazdanfar & Öhmann, 2015). However, the interest payable to lenders is tax-deductible and increases the return on equity (Faisal, Khan & Al-Aboud, 2017). Research even found that debt can boost the firm’s financial performance (Morley, 2016; Husnu & Ibnu, 2019). Although gearing ratios are regarded as an objective method (Robinson, Henry, Pirie, Broihahn & Cope, 2015) and results can be compared in an international context (Gencia & Mates, 2017), companies can use different accounting policies (see Appendix B) to improve their gearing ratio (Elliott, 2019). Consequently, direct comparison between companies using different approaches might not be feasible (Whittington, 2000).

For instance, researchers argue that the historical cost convention is more objective, whereas the fair value is closer related to the market (Magnan, Menini & Parbonetti, 2015).

Since the approaches are likely to provide different result, the interpretation of financial ratios and the direct comparison between companies might be distorted (Peterson, Schmardebeck & Wilks, 2015).

Furthermore, Karwowski (2016) examined that non-narrative reporting is vital to fully understand the business models of airlines. Research found that the tone of narrative reporting (see Appendix C) is related to market reactions around the disclosure date and that companies tend to use positive words to affect these reactions (Yekini, Wisniewski & Millo, 2016). Asay, Libby and Rennekemp (2018) stated that bad news tends to be written less readable and in the passive voice. This clearly influences the reader’s opinion and understanding of financial ratios (Garefalakis, Dimitras, Floros & Lemonakis, 2016).

Data for the gearing ratios of easyJet and Lufthansa as well as their narrative reporting and accounting policies have been obtained from their annual reports. Data for the industry analysis has been obtained from Bloomberg.

4. Data analysis and discussion

In 2019, Lufthansa’s gearing ratio was 63.12% (see Appendix D), an increase by 11.76% compared to 2018 (Figure 2). It seems to be significantly dependent on debt, because it’s gearing ratio is greater than 50%. Likewise, easyJet’s gearing ratio increased by 30.51% (Figure 2). However, since the gearing ratio is still under 50%, easyJet is considered a lower geared company and depends more on equity.

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Figure 2: Gearing ratios of Lufthansa (Lufthansa, 2019) and easyJet (easyJet, 2019)

An external reason for these developments is the current low interest rates, because lending money becomes even cheaper (Chatterjee & Eyigungor, 2019). A significant internal reason for Lufthansa is the investment of several million Euros in the research and development of sustainable alternative fuels (Lufthansa, n.d.). Likewise, easyJet started spending £25 million a year to offset its carbon emissions (Rehal, 2019).

Lufthansa’s high gearing ratio can increase financial risks such as financial distress (Baker & Martin, 2011), which destabilises shareholder’s return (Morrell, 2007). Moreover, it can cause hidden costs, for example poor credit terms (Cornaggia, 2011) and cash restrictions (Drake & Fabozzi, 2010). Lufthansa’s financial position is likely to be less stable than easyJet’s position, because it is more dependent on lenders, meaning higher interest payments. Since January 2019, Lufthansa’s share price (Figure 3) decreased by 14.90%, whereas easyJet’s share price increased by 33.12%. Lufthansa had to announce a profit warning, because of “intense price competition” and instability in the market (Riley, 2019). A study disclosed the correlation between the increasing number of low-cost airlines and the rise in debt of incumbents in the industry (Parise, 2018). Lufthansa’s high gearing might have added additional risks and increased fixed costs, which are not preferable in times of price competition. In contrast, easyJet’s low gearing ratio seems to have provided stability. EasyJet even became a FTSE100 member in December 2019 (Partridge, 2019).

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Figure 3: Share price performance of Lufthansa and easyJet's shares (Bloomberg, n.d.)

The airline industry is significantly different from other industries, because it is especially volatile (Morrell, 2018). As a consequence, the financial performance of Lufthansa and easyJet need to be compared with companies in the same industry. An analysis of the industry average facilitates the determination of the relative position of a firm in the market (Aithal, 2017). It seems to be feasible to analyse the companies’ financial performance in an international context, because both companies operate internationally and belong to the continent’s leading airlines (Spero, 2018).

EasyJet significantly outperformed the FTSE250’s average gearing ratio of 46.67% in 2018 (see Appendix E). However, an analysis of the global competition (Figure 4) should be conducted, too, because both companies are continentally leading firms and operate across national boundaries (Spero, 2018; see Appendix F). This analysis shows that easyJet also outperforms the global industry average of 52.77%, whereas Lufthansa has a higher gearing ratio than most of its international competitors. It underlines that, in contrast to Lufthansa, easyJet has a strong performance and solid financial position in an international comparison.

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Figure 4: Industry analysis (Bloomberg, n.d.)

Both EasyJet and its international competitor Lufthansa follow the IFRS standards and prepare their accounts based on the historical cost convention (easyJet, 2018; Lufthansa, 2018). This could be considered the most objective convention, although the fair value is closer related to the market (Magnan, Menini & Parbonetti, 2015). EasyJet and Lufthansa prepare short-term and long-term borrowings based on their historical costs. This approach is more prudence (Thalassinos, 2017). Ordinary shares are classified as equity. EasyJet and Lufthansa directly deduct incremental costs from the new ordinary shares. Dividend distributions to the shareholders are recognized as a liability in the period in which the dividend is approved by the shareholders. In the following years, the value of the shares is measured based on the market value (easyJet, 2018; Lufthansa, 2018), which is comparable and relevant. As both companies apply the same policies, the analysis is not influenced (Elliott, 2019).

Furthermore, research found that the tone of narrative reporting is related to market reactions around the disclosure date and that companies tend to use positive words to affect these reactions (Yekini, Wisniewski & Millo, 2016). In its non-financial report, Lufthansa neutrally explains how it fights corruption and bribery, shows respect for human rights and guarantees sustainability in the supply chain (Lufthansa, 2918). Generally, the non-financial report is understandable and addresses several stakeholder interests in a balanced way. In contrast, the tone of easyJet’s narrative report is more optimistic and positive developments are stressed. In the corporate governance section, the firm optimistically states how risks are mitigated and managed. Moreover, it is striking that positive news was often published at the beginning of the week, which again influences the market reaction immediately in a positive way (Niessner, 2014). As a consequence, stakeholders might have a more positive impression of easyJet than of Lufthansa because of the positiveness of narrative reporting (Yekini, Wisniewski & Millo, 2016).

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