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Financial Analysis Part 2 - Time Value of Money

by David Wyndham 29. June 2018 11:15
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Aircraft Financial Analysis

In the previous blog post I introduced the criteria for a financial analysis.  Recall that the goal of the financial analysis is to identify the aircraft that does the job for the least money.

The financial analysis should analyze all of the costs associated with the aircraft: acquisition cost, operating costs, depreciation and taxes, and the potential residual value after a set term. If the aircraft is to be used in a commercial operation, you will need to make assumptions regarding potential revenues as well. All of these considerations are important and needed to complete the analysis. Use the same set of assumptions for each aircraft to ensure that you get a true comparison.

The analysis tool to perform the financial analysis is the life cycle cost. In addition to showing the expenses, revenues, taxes as necessary, and a cash flow, there is one more thing remaining. The time-value of money.

The cash flow, or the monies in and out for pre and post tax, may be very different for the aircraft and the scenario. For instance, option A may be a cash purchase, option B, a loan, and option C, an operating lease. For the same aircraft, the cash flows will be dramatically different. Option A has a large cash outflow at the start in the form of the acquisition cost. Option B just has a down payment, but also has interest on the outstanding balance of the loan. Both of these purchase options do have the revenue in the form of the residual value estimate at the end of the term. The lease has no acquisition cost, but no revenue at lease end either. 

For a commercial operation, cash flow is king. At any given time if the money leaving in the form of expenses is not covered by the revenue coming in plus the money in the bank, you are not in business much longer. For a not-for-hire operation, the cash flow remains negative until you sell the aircraft where they may be a “profit.”

There is one more important consideration to consider, the timing of the expenses and revenues. Regardless of for hire or not, when the expenses occur as well as their magnitude is important. 

The time-value of money places importance on the timing of a revenue or expense occurs. Think of interest. If I invest $1,000 at 5% per year, I'll have $1,050 at the end of a year. Similarly, if I owe you a $1,000, and I pay you today, I need $1,000. But, if I can wait a year to pay you, I can invest $953 at 5% and end up with $1,000 after a year. Taking the time-value of money into account allows you to compare different streams of revenues and expenses  (i.e. cash flows) to see which one has the better time-value. Each future revenue and expense has a value in today’s dollars, or a Present value.

The Net Present Value is the sum of the present values of these future cash flows (revenues and expenses) less my initial investment. It takes into account my assigned value of money and inflation. An NPV greater than zero means I’ve made a profit. A zero NPV is break-even while a negative NPV is a loss. For a not-for-hire operation, minimizing the loss is the goal.

Terms used to describe the time-value "interest rate" include return on investment (commercial operations) and net present value (non-revenue operations like a corporate flight department or government). These are usually abbreviated as ROI and NPV respectively. 

What is a typical percent to use for the ROI/NPV analysis? You usually don't have to make one up. Government agencies usually look at the cost of borrowing money - Treasury Bill interest rates for example. Corporations have expected returns and use that for all major purchases. If you are in a large organization, just call the financial department, the CFO, comptroller, etc. and ask them for the relevant rate and your organization's marginal take rate. They will be impressed at your level of understanding!

Now that you have your costs, ROI/NPV rate, and marginal tax rate, how do you perform the analysis? Prior to spreadsheets, it was a time-consuming process. Today, there are spreadsheet applications that, given the proper data entry, will quickly calculate cash flows and ROI/NPV. Our company has a tool, Life Cycle Cost, that has a built in aircraft database that allows you to do all of the analysis mentioned here. I believe it is the only database plus software of its kind that does all these calculations specifically for aircraft.

The financial analysis with NPV takes into account all of the variables and calculates the net return for the option. This financial analysis allows you to rank order the capable aircraft to find the one that does the required job for the money.

One last warning, never let a spreadsheet make your decision for you. 

Aircraft A may be technically adequate for your mission and have the most favorable NPV. Aircraft B may exceed all your requirements but have a less attractive NPV. Since both Aircraft A and Aircraft B meet your technical needs, Aircraft A is the financial best alternative. But, the financial decision maker may feel that Aircraft B has a better value, or “more bang for the buck” and favor that option. As a consultant or analyst, my job stops at the technical and financial ranking. The decision maker, the person who signs the check, gets the final word.

 

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David Wyndham | Flight Department

Safety Management Systems (SMS) in Aviation

by Tori Williams 1. June 2018 21:37
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There is nothing more important in the aviation industry than safety. Every law, rule, or procedure has its roots in the general objective of increasing safety. Due to the fact that it is always being improved upon and innovated within, the United States’ national airspace system is one of the safest in the world. Today I would like to take a look at one of the newest pieces of regulation regarding safety in aviation, Safety Management Systems (SMS).

Historically, the process for improving safety was purely reactionary. Authorities would wait for an accident, investigate the accident to identify the cause, and then make changes to avoid the same accident in the future. This is ineffective, as it can solve one or two problems at a time but not address the less obvious contributing factors to the accident. Of course, accidents will continue to be investigated and learned from, but there is a new system that takes a more preventative approach.

Safety Management Systems (SMS) is a core concept in the aviation industry and recognized by both FAA and ICAO. This structured and business-like approach to managing and improving safety in all facets of the aviation industry has been explained by the FAA in a series of Advisory Circulars.

Is a SMS mandatory for all aviation operations? Not quite. For example, SMS for all part 139 certificated airports was proposed in the Notice of Proposed Rule Making (NPRM) in October 2010, however, in 2016 the FAA issued a Supplemental Notice of Proposed Rulemaking (SNPRM) which reduced the number of airports that needed an SMS to 265 airports that are certified under Part 139; airports that must have an SMS program include the following:

- classified as a small, medium, or large hub airport in the National Plan of Integrated Airport Systems;

- identified by the U.S. Customs and Border Protection as a port of entry, designated international airport, landing rights airport, or user fee airport; or

- identified as having more than 100,000 total annual operations.

This requirement maximizes safety benefits in the least burdensome manner and is consistent with international standards. Airports that are not required to have an SMS may still use FAA resources and implement selected practices to ensure safety at their airport. A full SMS plan may take months to create, and in some cases require assistance from an outside consulting firm.

The Four Components of SMS

Safety Management Systems has been divided into four distinct components; Safety Policy, Safety Risk Management, Safety Assurance, and Safety Promotion. Each has their own influence on SMS, and they come together to form a complete SMS program. Here is a brief description of each component.

Safety Policy: This is management’s commitment to safety, formally expressed in a statement of the organization's safety policy. A safety policy is written and agreed upon by top management and outlines the exact processes and plans the organization has to achieve desired safety outcomes. This should be the beginning of a positive safety culture that encourages employees to take ownership over their organization’s safety and to ensure they can report safety issues without fear of being reprimanded.

Safety Risk Management (SRM): This component looks at the present and future hazards and risks that the organization faces, then determines if there is an adequate risk control in place to mitigate them. This step often includes a Risk Matrix, or a grid analyzing the likeliness and severity of all possible risk scenarios. This component of SMS is vital for continually analyzing the effectiveness of current risk mitigation methods.

Safety Assurance: Safety Assurance is characterized by self-auditing, external auditing, and safety oversight. This component ensures that the steps taken in safety policy and safety risk management are helping the organization reach their desired safety outcomes. Proper resource allocation and data collecting are vital for this component, as it relies partially on historical information.

Safety Promotion: The human element is at the core of SMS. Having properly trained employees who are passionate about safety will help any organization reach their safety objectives. This component of SMS is all about having a Safety Manager who provides information and training for safety issues relevant to the specific jobs at the airport.

I hope that this brief overview of Safety Management Systems has taught you something new about an effective safety program. The great thing about SMS is that it can be applied to any industry, scenario, and operation. The FAA mandating SMS for certain sectors of aviation is a great move that I believe will eliminate quite a few accidents in the future. What do you think of SMS? Let me know in the comments!

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