Use the information provided in Analyst Adjustments 10.1(***shown at bottom below questions***) for Southwest Airlines along with the infor- mation below to answer the requirements.

$ millions 2013 2014 2015

Net operating assets (NOA). . . . . . . . . . . . . . .. $ 7,004 $ 6,479 $ 7,485

Net nonoperating obligations (NNO) . . . . . . . . . . (332) (296) 127

Total stockholders equity . . . . . . . . . . . . . . . . . .7,336 6,775 7,358

Net nonoperating expense (NNE). . . . . . . . . . 64 63 51

Net operating profit after tax (NOPAT). . . . . . . . .818 1,199 2,232

Net income . . . . . . . . . . . . . . . . . . . . .. . . . . . . . 754 1,136 2,181

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,699 18,605 19,820

Required

a.Compute the following ratios using the unadjusted and the adjusted numbers for each year. For sim- plicity only, use year-end balances for NOA, NNO, and equity.

Return on equity (ROE)

Return on net operating assets (RNOA)

Net operating profit margin (NOPM)

Net operating asset turnover (NOAT)

Financial leverage (FLEV) b.Does the lease capitalization make a large difference in any of these ratios? Explain.

****Analyst adjustments 10.1 Information shown below***

A typical financial statement analysis includes data for two to three years. To expand our analysis of the operating leases for Southwest Airlines for 2013 to 2015, we must obtain the lease footnotes from the form 10-K for each year separately. It would not be accurate to use $3,188 million, the 2015 capitalized operating lease amount determined above, for 2013 and 2014. Doing so can introduce errors because Southwest (like all companies) routinely changes the level of its operating leases in response to changes in the business environment. Southwests lease payment commitments for 2013 through 2015 follow.

Southwest Airlines operating lease payment commitments

$ millions 2013 2014 2015

Year 1. . . . . . . . . .. . . . . . . . ... . $ 637 $ 684 $ 557

Year 2. . . . . . . . . . . . . . . . . . .... .565 636 545

Year 3. .. . . . . . . . . . . . . ... . .... . 438 592 474

Year 4. . . . . . . . . . . . . .. . . . ...... 410 496 407

Year 5. . . . . . . . . . . . . . . . . ... . . 327 430 307

Thereafter . . . . . . . . . . . . . .... . 1,513 2,317 1,529

Total. . . . . . . . . . . . . . . . . . ..... . 3,890 5,155 3,819

A proper analysis must determine the present value of lease payments for each year. A common simplifying assumption is to hold constant the interest rate on the leases across the three year analysis period. Unless rates change drastically, this assumption will not introduce significant measurement errors. Using the 3.94% rate determined from the 2015 capital leases, we compute the present value for each year and use these amounts to reformulate key income statement and balance sheet items, as follows.

Balance Sheet Adjustments ($ millions) 2013 2014 2015

Net operating assets (NOA). . . . . . . . . . . . . . . . . . ...... . +3,267 +4,244 +3,188

Net nonoperating obligations (NNO) . . . . . . . . . . . . ...... +3,267 +4,244 +3,188

Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... . . 0 0 0

Income Statements Adjustments ($ millions) 2013 2014 2015

Interest expense (Capitalized amount x 3.94%). . . . . . ..... +129 +167 +126

Net nonoperating expense, NNE (Interest expense x [1-37%]) . . ..... +81 +105 +79

Net operating profit after tax, NOPAT. . . . . . . . . . . . . . . . . . . . . ..... . .+81 +105 +79

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... . . . 0 0 0

These adjustments have a big impact on our evaluation of Southwest Airlines performance. The largest impact is to RNOA and FLEV because NOA and NNO both change markedly for all three years. The effect of the adjustment on NOPAT is relatively small, which is common, and thus, NOPM is relatively unaffected. Of course, ROE remains unchanged because neither net income nor equity are impacted when we capitalize operating leases.