ACCOUNTING AND FINANCEACCOUNTING AND FINANCE

FinanceFinance Manage Manage Capital StructureCapital Structure: “Mix” of Funding : “Mix” of Funding

Sources (Internal, Debt or Equity)Sources (Internal, Debt or Equity) Implications of Choices: Value and GovernanceImplications of Choices: Value and Governance

PURPOSEAccountingAccounting Record and Report Financial ActivitiesRecord and Report Financial Activities Regulatory Compliance and TaxationRegulatory Compliance and Taxation

ACCOUNTING’S FOCUSACCOUNTING’S FOCUS

TAXATIONTAXATION Adjustments that convert Profits into IncomeAdjustments that convert Profits into Income

REGULATIONREGULATION Non-Compliant or Unacceptable PracticesNon-Compliant or Unacceptable Practices

CONSISTENCYCONSISTENCY Needed for Comparative Decision-MakingNeeded for Comparative Decision-Making

TWO PERSPECTIVES

Financial Accounting Prepare Financial Reports for External Prepare Financial Reports for External

Parties (Investors, Creditors and Tax and Parties (Investors, Creditors and Tax and Regulatory Authorities)Regulatory Authorities)

Managerial Accounting Prepare Information for Internal Analysis Prepare Information for Internal Analysis

and Strategic Decision-makingand Strategic Decision-making

FINANCE’S FOCUSFINANCE’S FOCUS

Manage Capital Structure - Manage Capital Structure - Reconcile Sources/Uses of Reconcile Sources/Uses of CashCash

Timing and Amounts (Operating and Capital)Timing and Amounts (Operating and Capital)

Implications of Capital Implications of Capital Structure ChoicesStructure Choices

Stockholder Rights (Equity and Internal) versus Stockholder Rights (Equity and Internal) versus Cash Flow Claims (Debt)Cash Flow Claims (Debt)

Essential Accounting ReportsEssential Accounting Reports

Balance Sheet

Income Statement

Statement Of Cash

Flows

BALANCE SHEETBALANCE SHEET

Reports Financial Condition as of Specified Date (Month/Quarter/Year End)

Reported Amounts may be Historical Cost or Estimates (Which is more Reliable?)

Reports Assets, Liabilities Reports Assets, Liabilities and Equityand Equity Assets: Property Owned by Firm Liabilities: Debts and Financial

Obligations Equity: Stock Investments/Retained

Earnings

ESSENTIAL ACCOUNTING CONCEPTSESSENTIAL ACCOUNTING CONCEPTS

Variation for Business ValuationVariation for Business Valuation Equity = Assets – LiabilitiesEquity = Assets – Liabilities

* Answers Question of “Why is it called a ‘Balance Sheet?’”

THE ACCOUNTING EQUATION

Assets = Liabilities + EquityAssets = Liabilities + Equity**

INCOME STATEMENTINCOME STATEMENT

Reports Firm’s Financial Performance

(1) Revenues, (2) Expenses, (3) Profits and (4) Net Income Information Reported for Prior

Period (Month, Quarter or Year)

Profits are Results of Firm’s Operations Revenues – Expenses = Profit (Loss)

Net Income includes Allowable Adjustments (Tax and Investment Reports)

ACCOUNTING QUANDRIESACCOUNTING QUANDRIES

Which Rule Provides Better Information?Which Rule Provides Better Information?

Should Transactions be Recorded and Should Transactions be Recorded and Reported…Reported…

When Cash is Received or Paid (When Cash is Received or Paid (Cash Cash BasisBasis) or...) or...When Service Performed or Product When Service Performed or Product Delivered (Delivered (Accrual BasisAccrual Basis))

GAAP says, “Report Transactions when GAAP says, “Report Transactions when Primary Purpose accomplished” (Payment Primary Purpose accomplished” (Payment not relevant)not relevant)

Management and Creditors need to know Management and Creditors need to know about Firm’s Cashabout Firm’s Cash

STATEMENT OF CASH FLOWSSTATEMENT OF CASH FLOWS

Reports Sources and Uses of Cash … Categorized by Activity

OPERATINGOPERATING – Cash Used in/Generated – Cash Used in/Generated by Core Businessby Core Business

INVESTINGINVESTING – Cash Used in/Generated – Cash Used in/Generated by Buying/Selling Assetsby Buying/Selling Assets

FINANCINGFINANCING – Cash Used to pay Debts – Cash Used to pay Debts or Dividends/Generated from Debt or or Dividends/Generated from Debt or Equity Equity

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders Southwest Airlines Co.

We have audited the accompanying consolidated balance sheet of Southwest Airlines Co. as of December 31, 2009 and 2008, and the related consolidated statement of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Southwest Airlines Co. at December 31, 2009 and 2008, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Southwest Airlines Co.’s internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated January 29, 2010 expressed an unqualified opinion thereon.

/s/Ernst & Young LLP

Dallas, Texas January 29, 2010

ACCOUNTING ISSUES: AUDITOR’S OPINIONACCOUNTING ISSUES: AUDITOR’S OPINION

(1) Accountants are Certified, not Information and (2) Statements are “Fair Presentation”; Accuracy is Management’s Responsibility

ACCOUNTING ISSUES: SOX CERTIFICATIONACCOUNTING ISSUES: SOX CERTIFICATION

(1) Personal responsibility for Disclosures, (2) Enhanced Internal Controls and (3) More Disclosures

Question: SOX enacted in 2002. Did it keep current financial crisis from being worse? Or did it make things worse?

THREE ESSENTIAL METRICSTHREE ESSENTIAL METRICS

Current RatioCurrent Ratio

Debt-to-Equity RatioDebt-to-Equity Ratio

Return-on-Equity RatioReturn-on-Equity Ratio

FORMULAFORMULA: Current Assets : Current Assets Current Liabilities Current Liabilities

PURPOSEPURPOSE: Assesses whether Firm can meet : Assesses whether Firm can meet Near-term ObligationsNear-term ObligationsNOTE: Analyze Trends - Are changes caused by NOTE: Analyze Trends - Are changes caused by

decreasing cash or increasing liabilities? decreasing cash or increasing liabilities? Should not Should not consistentlyconsistently be less than 1:1 be less than 1:1

** (1) Capacity of Business to pay (1) Capacity of Business to pay Current LiabilitiesCurrent Liabilities

(2) Extent of Effect on Asset’s Value (2) Extent of Effect on Asset’s Value caused by Sale (conversion to cash)caused by Sale (conversion to cash)

†† Current AssetsCurrent Assets: Can or Will be : Can or Will be Converted to Cash within 1 YearConverted to Cash within 1 Year

Current LiabilitiesCurrent Liabilities: Due within 1 : Due within 1 YearYear

THREE ESSENTIAL METRICSTHREE ESSENTIAL METRICS

CURRENT CURRENT RATIORATIO

MeasuresMeasures LIQUIDITY* by Comparing by Comparing CurrentCurrent†† Assets with Assets with CurrentCurrent† Liabilities Liabilities

THREE ESSENTIAL METRICSTHREE ESSENTIAL METRICS

DEBT-TO-EQUITY RATIODEBT-TO-EQUITY RATIOAssesses Firm’s Capital StructureAssesses Firm’s Capital Structure**

((LEVERAGINGLEVERAGING)) FORMULAFORMULA: Long-TermDebt : Long-TermDebt Equity Equity PURPOSE: PURPOSE: Evaluate Debt’s Fixed-cost Evaluate Debt’s Fixed-cost

BurdenBurden

Remember: Debt requires Periodic Cash Payments; Equity does not

** Mix of Sources of Funds used to Mix of Sources of Funds used to Finance Firm’s Capital Costs Finance Firm’s Capital Costs and Operating Expensesand Operating Expenses

THREE ESSENTIAL METRICSTHREE ESSENTIAL METRICS

RETURN-ON-EQUITYRETURN-ON-EQUITYMeasures Rate of Return Earned for ShareholdersMeasures Rate of Return Earned for Shareholders

FORMULA: Net Income FORMULA: Net Income Shareholders’ Shareholders’ EquityEquity

Evaluates Management’s Evaluates Management’s EfficiencyEfficiencyNOTE: Not Return-on-Investment

FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

RECONCILE SOURCES/ USES OF RECONCILE SOURCES/ USES OF CASHCASH

Operating NeedsOperating Needs:: Timing and Timing and AmountsAmounts

Capital NeedsCapital Needs:: Growth, Growth, Contraction Contraction or or New EnterprisesNew Enterprises

Internal and External ContingenciesInternal and External Contingencies

Strategic Problem: Economically balance Profit-Producing Characteristics of Assets with Implications of Capital Structure Choices

CAPITAL STRUCTURECAPITAL STRUCTURE

FINANCING: FINANCING: INTERNALINTERNAL oror EXTERNALEXTERNAL

Choice depends on Timing, Choice depends on Timing, Available Amounts and Costs to Available Amounts and Costs to Obtain Obtain andand… …

Implications for Implications for OperationsOperations (Debt’s Claims on Cash (Debt’s Claims on Cash Flow/Assets) and Flow/Assets) and GovernanceGovernance (Common Stockholders’ Right to (Common Stockholders’ Right to Vote)Vote)

CAPITAL STRUCTURECAPITAL STRUCTURE

INTERNALLY GENERATED INTERNALLY GENERATED FINANCINGFINANCING

Retained Earnings (No Dividend Retained Earnings (No Dividend Payout)Payout)

Vendor Financing (Accounts Vendor Financing (Accounts Payable) orPayable) or

Sales Terms (Accounts Sales Terms (Accounts Receivable)Receivable)

Advantages:Advantages: No No Application/Approval ProcessApplication/Approval Process

Immediately Immediately AvailableAvailable

No Direct No Direct Governance ImplicationsGovernance Implications

CAPITAL STRUCTURECAPITAL STRUCTURE

EXTERNAL FUNDING: DEBTEXTERNAL FUNDING: DEBTObtained from Commercial Banks, Obtained from Commercial Banks,

Finance Companies and Private Finance Companies and Private PartiesParties

Subject to Creditworthiness/Debt Subject to Creditworthiness/Debt Servicing CapacityServicing Capacity

Negative Covenants: Restrictions on Negative Covenants: Restrictions on Other Borrowings, Profitability, Current Other Borrowings, Profitability, Current Ratio and moreRatio and more

Cash Flow Implications: Repayment Cash Flow Implications: Repayment Terms, Interest Charges, Fees, Reports Terms, Interest Charges, Fees, Reports and more…and more…

CAPITAL STRUCTURECAPITAL STRUCTURE

EXTERNAL FUNDING: EXTERNAL FUNDING: EQUITYEQUITY

Public EquityPublic Equity: Obtained from : Obtained from Investment Banker Investment Banker through Initial through Initial Public Offering (IPO)/Stock Issue or Public Offering (IPO)/Stock Issue or Private EquityPrivate Equity: : Venture CapitalistVenture Capitalist

Sale of Fractional OwnershipSale of Fractional Ownership: Cost is : Cost is tradeoff between Capital received and tradeoff between Capital received and Control Given UpControl Given Up

Control RightsControl Rights: Employment : Employment Agreements, Board Memberships, Agreements, Board Memberships, Decision-Making, Voting Interests…Decision-Making, Voting Interests…

FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

CAPITAL STRUCTURE: CAPITAL STRUCTURE: IMPLICATIONSIMPLICATIONS

Internal Funds (Retained Earnings)Internal Funds (Retained Earnings) Shareholder Expectations Shareholder Expectations

External Debt (Bonds and Loans)External Debt (Bonds and Loans) Covenants may restrict Growth; Rate RiskCovenants may restrict Growth; Rate Risk

External Equity (Sale of Ownership External Equity (Sale of Ownership Interest)Interest) Voting RightsVoting Rights

# Shares ($10 Par Value*) 100 50 20

$ 850

(800)

$ 50

-----

$ 50

(20)

$ 30

30¢

The “Magic” of LeveragingThe “Magic” of Leveraging

What happens to EPS when What happens to EPS when Capital Structure Changes?Capital Structure Changes?

• 50% Debt = 50% Increase50% Debt = 50% Increase• 80% Debt = EPS 80% Debt = EPS Triples!Triples!

What happens if What happens if (when) Revenues (when) Revenues decrease to $850?decrease to $850?

Does it help to reduce Interest Rate by 25% to 7Does it help to reduce Interest Rate by 25% to 7½½%?%?

Answer: No. Interest Expense decreases to $60 which only reduces Loss to (50¢).

$ 850

(800)

$ 50

(50)

$ 0

------

$ 0

$ 0

$ 850

(800)

$ 50

(80)

$ (30)

-----

$ (30)

$ (1.50)

* “Par Value” is a Nominal, Minimum Value assigned to a Company’s stock upon its incorporation

““Howard, Think about your Capital Structure…”Howard, Think about your Capital Structure…”

SouthwestSouthwest’s ’s

Business Business PlanPlan

June 18, 1971: Began Service June 18, 1971: Began Service (Organized 1967)(Organized 1967)

May 2003: Largest Domestic Carrier May 2003: Largest Domestic Carrier

More than 3,400 Daily Flights – 64% More than 3,400 Daily Flights – 64% Market ShareMarket Share

Flies only Boeing 737 Jets: 537 Planes Flies only Boeing 737 Jets: 537 Planes in Fleet. Each flies about 12 hours in Fleet. Each flies about 12 hours daily (6.25 Trips)daily (6.25 Trips)

83% Unionized (73% at General 83% Unionized (73% at General MotorsMotors))

101.4 Million Passengers flew on 101.4 Million Passengers flew on Southwest – Ticket Sold every 2.7 Southwest – Ticket Sold every 2.7 secondsseconds20092009: Received 90,043 Resumes - : Received 90,043 Resumes - Hired 831 “Southwest Warriors” Hired 831 “Southwest Warriors” (1:108)(1:108)Consumed 1.4 Billion Gallons of Consumed 1.4 Billion Gallons of Jet Fuel - Average price: Jet Fuel - Average price: $1.97/Gallon$1.97/GallonServed 63.2 Million Cans of Served 63.2 Million Cans of Soda/Water, 14.3 Million “Adult Soda/Water, 14.3 Million “Adult Beverages”Beverages”and 90 Million Bags of Peanutsand 90 Million Bags of Peanuts

Name Two things Southwest has Name Two things Southwest has NEVERNEVER done?done?

Answer: Answer: (1) Lost Money - Profitable for 37 (1) Lost Money - Profitable for 37 Consecutive Years and (2) Laid Anyone Off Consecutive Years and (2) Laid Anyone Off

Does Capital Structure Matter?Does Capital Structure Matter?

Long-Term Debt to Stockholders’ (Book) Equity

Delta $63.90 to 1

Continental

$ 8.97 to 1

Jet Blue $ 1.90 to 1

Southwest

$ 0.61 to 1

Net Income (Loss)Millions

( $1,237)

( $282)

$ 58$ 58

$ 99$ 99

Let’s “dive into” some of Southwest’s Numbers…Let’s “dive into” some of Southwest’s Numbers…

Fuel Costs: 18% Lower Fuel Costs ($669M )

Full-Time Employees: 780 fewer Employees, but Salaries and Wages were 3.8% higher

Revenues: 96% from Passenger Ticket Sales

Salaries: 34.4% (2009) versus 31.6% (2008)

Taxes: 39.6% Effective Rate

Valuation Analysis

Stock Price (April 14, 2010) $ 13.40

Market Value(742.8 M Shares*) $ 9,953 M

Book Value(Total Stockholders’ Equity $ 5,466 M

Market Value/Book Value 182%

Earnings per Share ($99/742M) $ 0.13

Stock Price Multiple ($13.40/$0.13) 103.1 X

Net Income from Income Statement: $99 MillionNet Income from Income Statement: $99 Million

Comparative Ratio Analysis

2009 2008

Current Ratio 1.25:1 0.95:1

Debt-to-Equity 0.61:1 0.71:1

Return-on-Equity 1.8% 2.6%

*Shares Outstanding (742.8 M) = Number Issued (807.6 M) less Number held in Treasury (64.8 M)*Shares Outstanding (742.8 M) = Number Issued (807.6 M) less Number held in Treasury (64.8 M)

Note Reconciliation of Note Reconciliation of Beginning/End-of-Period Cash Beginning/End-of-Period Cash with Cash on Balance Sheet with Cash on Balance Sheet

2009 Operations generated 2009 Operations generated Surplus Cash ($985M) used to Surplus Cash ($985M) used to Purchase Aircraft ($585M) and Purchase Aircraft ($585M) and Pay Revolving Credit Facility Pay Revolving Credit Facility ($400M)($400M)

Note : 2008 Operations did not Note : 2008 Operations did not produce sufficient Cash ($1.5 B produce sufficient Cash ($1.5 B Shortfall). Shortfall).

2010 plans call for purchasing 2010 plans call for purchasing 10 aircraft; 13 purchased in 2009 10 aircraft; 13 purchased in 2009 and 28 purchased in 2008and 28 purchased in 2008

Why Didn’t Anyone See This Why Didn’t Anyone See This Coming?Coming?Stock PriceStock Price

January 3, 2000January 3, 2000 $ 43.44$ 43.44

August 17 and 23, 2000August 17 and 23, 2000 90.0090.00

December 29, 2000December 29, 2000 83.1383.13

October 29, 2001October 29, 2001 13.8113.81

November 30, 2001November 30, 2001 26¢26¢

Significant EventsSignificant Events

Aug 2001Aug 2001 CEO Jeff Skilling Resigns (October CEO Jeff Skilling Resigns (October 2006 – Sentenced to 24 Years)2006 – Sentenced to 24 Years)

Nov 2001Nov 2001 Last 4 Years’ Earnings RestatedLast 4 Years’ Earnings RestatedBond Rating lowered to “Junk”Bond Rating lowered to “Junk”

Dec 2, 2001Dec 2, 2001 Files Chapter 11 (Reorganization) Files Chapter 11 (Reorganization) Bankruptcy PetitionBankruptcy Petition

Jan 1, 2004Jan 1, 2004 Bankruptcy converted to Chapter 7 Bankruptcy converted to Chapter 7 (Liquidation)(Liquidation)

Would Would studying studying Enron’s Enron’s

Statement of Statement of Cash Flows Cash Flows and a Little and a Little Common Common

Sense have Sense have saved saved

Billions?Billions?Note 9. Supplemental Note 9. Supplemental Cash Flow Cash Flow InformationInformation

Cash Payments for Income Taxes Cash Payments for Income Taxes 2000: $62 (4.4%*) 2000: $62 (4.4%*) [Federal Rate: 35%; *Effective Rate] [Federal Rate: 35%; *Effective Rate] 1999: $51 (5.1%*)1999: $51 (5.1%*)

1998: $73 (8.3%*)1998: $73 (8.3%*)

Note 16. Related Note 16. Related Party TransactionsParty Transactions

““In 2000 and 1999, Enron entered into transactions with limited partnerships * * * whose general In 2000 and 1999, Enron entered into transactions with limited partnerships * * * whose general partners’ managing member is a senior officer of Enron * * *[.] Management believes the terms of the partners’ managing member is a senior officer of Enron * * *[.] Management believes the terms of the transactions * * * were reasonable compared to those which could have been negotiated with unrelated transactions * * * were reasonable compared to those which could have been negotiated with unrelated third parties.”third parties.”

Nota BeneNota Bene Contrast 1998 and 1999 Cash Sources (Operations: 1/3 and Financing: 2/3) with 2000 Cash SourcesContrast 1998 and 1999 Cash Sources (Operations: 1/3 and Financing: 2/3) with 2000 Cash Sources