Links to China Southern Airlines Spreadsheet and Annual Reports

Please click on the following links for CSA's spreadsheet, annual reports and steps 3-5 and 7-8:

China Southern Airlines Spreadsheet

Annual Report 2018

Annual Report 2017

Annual Report 2016

ACCT13017  Steps 3-5 and 7-8 

ACCT13017 KCQ’s – Getting to know Southern China Air

Getting to know Southern China Air

Established in 1989, Southern China Air began operations and became one of the “Big 3” air carriers with Air China and China Eastern. They were the first airline to purchase Boeing aircrafts in 1995 and just one year later became the first airline to fly non-stop across the Pacific. By 2000 they added destinations to Sydney and Melbourne. In 2011 five Airbus A380 super-jumbo planes significantly increased passenger capacity and also company prestige. They continued to expand routes to Auckland, Brisbane, Melbourne, Perth, Sydney, Amsterdam, Auckland, Istanbul, Tbilisi, Los Angeles and Vancouver. By 2014 they were transporting more than one million passengers annually. Their advancements continue with the introduction of the Enhanced Rapid Transfer Service for international travellers, showcased in this review and electronic ‘BAGTAG’. Currently, they are customer service orientated focusing on building their brand.

The parent company of China Southern Airlines Ltd, China Southern Air Holding Co, is a state-owned enterprise that was supervised by State-owned Assets Supervision and Administration Commission of the State Council.  They provide passenger, cargo, mail delivery and other transport services throughout the world. With 840 passenger and cargo transport aircrafts and the most developed route networks, they have successfully served 140 million passengers annually. They are ranked 1^st in Asia and 3^rd in the world according to fleet scale and passenger turnover. Currently employing more than 100 831 staff, they are considered the safest Chinese airline, receiving 2 top safety awards.  Their headquarters are located in Guangzhou with 16 branches and 8 holding aviation subsidiaries and 22 domestic business departments, including locations in Hangzhou, Qingdao, Sydney and New York.

Getting a feel for the Annual Reports

The Consolidated Income Statement

It might seem obvious that the main operation of an airline is to supply passengers with a transport service over large distances, but reading through Southern China Air’s annual report shows it’s more complicated than that. The report states, “Substantially all of the Group’s operating revenue is attributable to airlines transport operations.” I was curious to understand what ‘transport operations’ included. Transport operations comprised of passenger revenue, cargo and mail revenue, make up the RMB 138,064 million total traffic revenue. That’s about $28,892,969,156 AUD! Most of this is earned through passengers both domestic and international, 92.74%, while cargo and mail revenue only attributes 7.26%.  

They advise a change in accounting policy according to IFRS 15 involving how revenue from contracts with customers is recognised. I recall a discussion during LAWS19033 Taxation Law A, concerning when revenue is recognised from the purchase of an airfare if the customer fails to use the flight. The argument involved the principle of recognising a revenue only when the service was provided, in the income statement and where the service was not provided, a liability would be recorded in the balance sheet. My understanding of IFRS 15 is recognising the revenue when an obligation is satisfied by transferring a promised good or service to a customer, which is when the customer obtains control of that good or service. Therefore, the revenue is recognised when the customer buys a ticket and then becomes the controller of the service, regardless if that service is unfulfilled, as the airline has no control of the customers actions.

They derive other income from commission income, hotel and tour operation income, general aviation income and ground services income. I noticed that other net income, mainly from government grants is separate from the operating revenue. I am intrigued about their treatment of government grants, since they are expected to receive a $4 billion capital injection in 2019. This is the largest grant since 2017, when they received $21 million.  It is peculiar to note the disappearance of all impairment of property, plant and equipment in 2018. Nothing jumps out as to why this has occurred and will require some digging. I am wondering if it ties in with gains/losses on disposal and their commitment to safety when it comes to their aircrafts.

The other stand out is the massive amount of operating expenses. It was no surprise to find that jet fuel costs were the biggest expense, followed by flight personnel payroll, aircraft leases and catering. There was also a good chunk of change given to a Civil Aviation Development Fund, I had no idea what this was and there is nothing in the notes. A quick google search revealed it was an aviation tax imposed by the Chinese government for the development of airports. I’m beginning to understand the major impacts on the financial statements by the  involvement from the government of a state-owned company.

I am expecting a significantly low economic profit, considering the huge drop in profit from 2017 to 2018, due to rising oil prices and increased competition.

The Balance Sheet

As expected, the biggest asset was plant, property and equipment. Aircrafts are notoriously expensive, and I noticed that there was construction in progress which means there is significant outlay before the asset can be used in producing revenue. This time around I had a better understanding of derivative financial instruments and deferred tax assets, but back in 2014 I had no idea. I remember being stumped and curious. Now it makes sense to adjust the value of assets according to exchange rates or interest rates and also adjust to suit tax accounting. Considering the large amount of cash and cash equivalents, I found restricted bank deposits surprising. It might be usual in China, but it wasn’t something that made sense. It will be interesting to compare other Chinese companies to see if this a reoccurring thing. There appears to be a large amount of prepaid expenses but no corresponding notes as to what they relate, which makes me curious.

I would expect prepaid revenue, or as listed in the liabilities, ‘sales in advance of carriage’, to relate to pre-payments of flights, as people usually book and pay for flight prior to departure. I also noticed a large amount of borrowings. This coupled with government grants suggests the high amount of capital needed for operating an airline. There is also a large amount of accrued expenses, which means the company has an obligation to pay for goods or services already provided, that have not been classified as accounts payable.

I am trying to make sense of all this, but it’s a very complicated machine, being kept well-greased by the Chinese government.  

General Comments

Understanding how a state-owned company operates is very complicated. The reliance on capital is not solely focused on shareholders or the worry of rejection of finance. There is also the country’s culture within the organisational culture to consider and the impact from other countries perceptions. For example, the current USA reaction to China and president Trump’s response have impacted trade relations, the trade war still being negotiated.  China Southern Airline’s focus on branding will have AIM (Asian Integrated Media Pty) work cut out for them in the fallout.

PEER FEEDBACK SHEET: ASS#1

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Step 1 KCQs
Step 2 KCQs
Step 3
Background information on company Comments/KCQs
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Step 4
Input company’s financial statements
Step 5 Restated Income statement Restated Balance sheet Commentary & discussion with others
Step 6 KCQs
Step 7 Calculation of ratios
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KCQ's Chapter 4

ACCT13017 KCQ’s Chapter 4

Dividends are the only thing equity investors are owed for their investment. This is what they expect, unlike an object when what you see is what you get, dividends are intangible and difficult to predict. I suppose another way to profit from an equity investment is to sell shares at a higher rate than paid for but that would be the end of the risk and would that be the getting the most from your investment? Dividends have the possibility of being paid for the life of the firm, almost indefinitely! It makes sense that we would be likely to predict return on equity by understanding the kind of leverage a firm has in making it profitable and how efficient is its employment. Kind of like why I’m studying this degree, to gain leverage in an employability but also to use the knowledge gained to my full advantage by investing wisely in an equity investment or self-employment in a business venture! In other words, making money and making the money work for me.

Abnormal Earnings and Restating Financial Statements

The term itself, abnormal, suggests the meaning of ordinary earnings which are not normal and the best kind of not normal, is above and beyond our expectations. When I studied Accounting for Decision making in 2014, this is how I explained economic profit, “My understanding is that economic profit attempts to measure the creation of wealth that exceeds the cost of the amount of capital invested.”  My understanding now is that the creation of wealth should more accurately be the creation of value or value expectation. The measurement derived from inputting the  drivers of Abnormal Earnings into the formulae:

AE = [ROE – (ρ_E – 1)] x BV

It’s still not clear to me how we would estimate a required rate of return? I can see how using the comprehensive income divided by the average book value would calculate the ROE as an actual rate of return but what would be acceptable as a required rate of return?

Also, how can I be sure what to include as my company’s total comprehensive income? Where so I find the evidence to include or exclude relevant amounts? This is going to be the tricky part of restating the financial statements in order to make the numbers talk!

I have reviewed the videos on PP&E to revamp on revaluations. I also thought depreciation may be another item to be wary. I noticed my company had 3 significant changes in accounting policies:

1.       IFRS 9 – Financial Instruments

2.       IFRS 15 – Revenue from contracts with customers

3.       IFRIC 22 – Foreign currency translations and advance consideration

These are the areas of interest and I will be analysing with scrutiny to obtain a conceptual view. It will be necessary to examine these interactions as a part of their operating activities as it involves input markets, customers and suppliers. The financial activities might be difficult to decipher and there are endless notes to poor over and it seems to be derived from government policy as well as accounting policy. This is important to distinguish between Net operating assets and net financial assets to determine the FCF and ascertaining debt or dividends. Much like holding on to your shares in an investment is likely to continue producing exponential returns, so too is holding on revenue producing assets, rather than selling them. Therefore, most of the added value in firm must come from the operating assets. It’s odd to think that many developed countries have an efficient debt markets, but it is kind of comforting that most firms have access to available finance. This would give the firm support in an uncertain market.

Restating Two Financial Statements

Balance Sheet

Although it seems like a straight forward task, separating the operating and financial activities can be confusing. I recall in ACCT11059 struggling to decide where goodwill and deferred tax fit. After gaining a better understanding of the accounting treatment of these items, it seems obvious they would be operating activities, although I intend to challenge this with a Facebook discussion. The main thing I remember about cash is that if a business runs out of it that is the end of business. So, it makes sense that some cash will be needed for operation and some for financial. China Southern Air would need some cash for customers but also for suppliers, especially fuel for operations. They do have a significant amount of cash and cash equivalents, therefore upon Martin’s advice I will be allocating a cash amount of least 1% of sales to operating assets and the rest to financial assets.

Income Statement

Analyse ROE: Leverage and Profitability

Leverage

FLEV = NFO/Equity

Impact of Leverage:  ROE = ROOA+(RNOA-ROOA)+(ROE-RNOA)

I imagine leverage to be similar to the way I fund my textbooks. I resell the old ones that I no longer use, plus the money I earn from selling cosmetics to avoid using the cash stores in my bank. Obviously, there is a lot more involved in a company, but essentially, it’s about their intention and ability to generate future profits. It seems to me leverage provides the company with strength for current and support for future operating activities. This affects their ability to create added value to equity investors by giving them assurance for sustainable returns.

Profitability

PM = OI (Operating Income after tax) / Sales

I understand the basic profit margin of selling something for than it costs and if a company doesn’t do this their cash supply rapidly depletes causing the company’s demise. I didn’t realise that 6% (in the US) is the average, as a sort of benchmark. I have no idea of the average profit margin for the airline industry and it will be interesting to compare this to my company. I imagine most of their profitability comes from airfares and cargo charges but I’m not sure how the effects of the previous changes in accounting policies have or will impact on the operating income. This will be an interesting story to unfold.

Analyse ROE: Leverage Revisited and Efficiency

ATO = Sales / NOA ;  1/ATO = NOA/Sales

Whenever I see sales as part of an equation, I immediately associate it with profit. Sales are generally the heart of a company, the reason they are in business and how they intend to make profit. So, I can link these activities with the company’s intention. An important aspect of Mintzberg’s 5 P’s. In this way I can think that RNOA has an interaction with PM and ATO, rather than a driver. The real drivers are in the story, the intention and culture of the company. I can see from the Ryman example that its important to have a balance of leverage, profitability and efficiency but the ability of a company to exceed these averages is the real story behind success.

ROE = RNOA + (FLEV x Spread) – the relationship of ROE and RNOA

NBC = NFE/NFO – Net Borrowing Cost

An important take out from this is understanding that leverage and spread on their own are not drivers of ROE compared to RNOA, it is the interaction, how they work together is important. My understanding is, a company can theoretically continually increase borrowings but that does not increase its proficiency to generate ROE or RNOA. I like the analogy of a firms gears. The cogs and levers all working together like a well-oiled machine. I can glean from the Ryman model how these accounting decisions reflects the anticipation or response to economic drivers. What economic drivers are affecting my company? Which assets should be focused on? How is the company financing now and in the future? Are they balancing leverage, profitability and efficiency? There are so many questions that require some exploring. The difficulty will be understanding an economic environment from another country. My though process has a democratic focus and to understand China I need to shift that focus to a communist regime. That will be the challenge to portray an accurate and reliable story of the company’s economic and business realities.