Southwest Airlines has been charting its own course in the a

Southwest Airlines has been charting its own course in the airline industry for 45 years. The company began operating as a short-haul, no-frills carrier in 1971, with only three Boeing 737 aircraft serving Dallas, Houston, and San Antonio, Texas, business commuters with peanuts and drinks rather than lunch or dinner between stops. The company has gained a reputation through the years of providing reliable, low-cost travel from close-in, smaller airports that are convenient for many business commuters or vacationers. Through the years, Southwest\'s business strategy has been to keep operating costs lower than other carriers, passing the savings on to custom ers in the form of low fares. As of December 31, 2012, Southwest was the largest domestic air carrier in the United States. It served 93 destinations in 41 states, the District of Columbia Puerto Rico, and six \"near-international countries\" including Mexico, Jamaica, the Bahamas Aruba, the Dominican Republic, and Bermuda, with a fleet of 687 aircraft. Despite turbulence in a very volatile industry, Southwest has managed to remain consistently profitable while other airlines have struggled. In 2014, the company earned $1.136 billion on operating revenue of $18.6 billion. The company has also retained more liquidity (cash) than other airlines. In 2011 Southwest purchased AirTran Airways, a competitor, largely with cash and stock.

Solution

Companies can prefer to classify the long term leases as operating leases as this keeps the liabilities off the balance sheet and the debt to capital ratio of the company is not disturbed and hence the company can raise capital at more competitive rates from banks or the capital market.

The disadvantage of this is that they cannot claim depreciation on the leased assets and hence the tax shield due to depreciation is not available for them. Also this liability is treated as a long term liability by many lenders and hence can work to their disadvantage as they do not get advantage of tax shield of depreciation and also the present value of liability is taken into account by lenders.

Few companies tend to take long term leases as capital leases as this provide them the advantage of depreciation tax shield. The disadvantage is that capital leases are treated on par with loan or debt and the balance sheet becomes more leveraged resulting in higher cost of capital for the firm to off set the risk of greater leverage.