AN INVESTIGATION OF LOCKHEED'S SOLVENCYBY USE OF FINANCIAL RATIOS

Edward George Bannat

NAVAL POSTGRADUATE SCHOOLMonterey, California

•AN INVEST I GATION OF LOCKHEED'S SOLVENCYBY USE OF FINANCIAL RATIOS

by

Edward George Bannat

June 1974

Thesis Advisor: James Fremgen'

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An Investigation of Lockheed's Solvencyby Use of

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Edward George Bannat

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This thesis is an application of the methodology in studies by Beaver andone by Dascher to an analysis of the financially troubled Lockheed AircraftCorporation. These three previous studies used financial ratios in attemptingto predict failure. All three studies were performed with firms that hadalready failed. Their results demonstrate that there is a significant differencein financial ratios of failed and non-failed firms. This difference is partic-ularly obvious when observing the non-liquid asset ratios.

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This thesis attempts to determine Lockheed's solvency in 1971,when it claimed to be facing bankruptcy. The conclusion is thatfailure in 1971 was, indeed, quite probable. In addition, Lockheed'sratios are analyzed during 1971-1972, as the firm has stated thatit faces a new crisis, though not nearly of the proportion of the 1971disaster. These last two years will serve as a starting point forfuture ratio analyses of Lockheed.

DD Form 1473, 1 Jan 73

S/N 0102-014-G601

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SECURITY CLASSIFICATION OF THIS P»0E(1Hi«n Dafa Enl.rad;

An Investigation of Lockheed's Solvencyby Use of

Financial Ratios

by

Edward George ^.Bannat

Lieutenant, United States NavyB. S. , United States Naval Academy, 1969

Submitted in partial fulfillment of the

requirements for the degree of

MASTER OF SCIENCE IN MANAGEMENT

from the

NAVAL POSTGRADUATE SCHOOL

June 1974

3 ?

ABSTRACT

This thesis is an application of the methodology in studies by-

Beaver and one by Dascher to an analysis of the financially troubled

Lockheed Aircraft Corporation. These three previous studies used

financial ratios in attempting to predict failure. All three studies

were performed with firms that had already failed. Their results

demonstrate that there is a significant difference in financial ratios

of failed and non-failed firms. This difference is particularly

obvious when observing the non-liquid asset ratios.

This thesis attempts to determine Lockheed's solvency in 1971,

when it claimed to be facing bankruptcy. The conclusion is that

failure in 1971 was, indeed, quite probable. In addition, Lockheed's

ratios are analyzed during 1971-1972, as the firm has stated that

it faces a new crisis, though not nearly of the proportion of the 1971

disaster. These last two years will serve as a starting point for

future ratio analyses of Lockheed.

TABLE OF CONTENTS

I. INTRODUCTION-- - --- 10

II. HISTORY OF LOCKHEED - 12

A. WAR'S END TO THE SIXTIES --- 13

B. THE SIXTIES 14

1. A Crisis Begins 15

2. L-1011 "Tristar" --- 17

C. THE EARLY SEVENTIES- 19

1. A New Crisis 19

III. THE SCOPE AND FOUNDATION OF THIS THESIS 21

A. BEAVER'S STUDIES 21

B. DASCHER'S STUDY 24

C. THE PRESENT STUDY 25

IV. DATA PRESENTATION 27

A. FOURTEEN BASIC RATIOS 27

B. THE FIRMS IN THE STUDY 29

C. DATA --- --- 31

V. ANALYSIS AND CONCLUSIONS 53

A. 1966-1970 53

1. Non- Liquid Asset Ratios 53

2. Liquid Asset Ratios 54

a. Liquid Assets /Total Assets Ratios 54

b. Liquid Assets /Current Debt Ratios 55

c. Turnover Ratios 56

3. Rankings 56

4. Conclusions of Thesis For Years 1966-1970-- 57

B. 1971-1972 58

1. Non- Liquid Asset Ratios 58

2. Liquid Asset Ratios 58

3. Rankings 59

4. Conclusions of The Thesis For Years 1971-1972 59

APPENDIX A Company Measures 61

APPENDIX B Company Ratios, Means and Standard Deviations 67

LIST OF REFERENCES 76

INITIAL DISTRIBUTION LIST 78

\

LIST OF TABLES

Table Description Page Number

I Measures and Definitions 28

II Companies 3q

III Ratio Rankings 52

Figures

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

LIST OF FIGURES

Description

Working capital flow/total debt histogram

Net monetary assets flow/total debt histogram

Funds flow /total debthistogram

Net income /total assetshistogram

Total debt /total assetshistogram

Current assets /total

assets histogram

Quick assets /total

assets histogram

Working Capital /total

assets histogram

Cash/total assets histogram

Current assets /currentdebt histogram

Quick assets /current debthistogram

Cash/current debt histogram

Current assets /sales histogram

Quick assets /sales histogram

Working capital/sales histogram

Cash/sales histogram

Working capital flow/total debt graph

Net monetary assets flow/total debt graph

Page Number

32

33

34

35

36

37

38

39

40

41

42

43

44

45

46

47

48

48

8

19 Funds flow /total debtgraph 48

20 Net income /total assetsgraph 48

21 Total debt /total assetsgraph 49

22 Current, as sets /total

assets graph 49

23 Quick assets /total

assets graph 49

24 Working capital /total

assets graph 49

25 Cash/total assets graph 50

26 Current assets /currentdebt graph 50

27 Quick assets /currentdebt graph 50

28 Cash/current debt graph 50

29 Current assets /sales graph 51

30 Quick assets /sales graph 51

31 Working capital /salesgraph 51

32 Cash/sales graph 51

9

I. INTRODUCTION

Lockheed Aircraft Corporation claimed to be facing bankruptcy

in 1971 because it was running out of cash. [^Ref. lj[ This situation,

coupled with the actual bankruptcy of Rolls-Royce Ltd., caused the

British government and Lockheed to petition the United States

Government for an emergency loan guarantee of $250 million.

The guarantee was approved in the form of a bill called the

Emergency Loan Guarantee Act by the Senate on a slim 49-48 vote.

The closeness of the vote hints at the controversy that preceeded

the final decision. Many senators felt that Lockheed had no grounds

for requesting this assistance and felt that the company would receive

financial help from its banks with or without a guarantee. Others

felt that the natural processes of competition were at work and the

government had no right in manipulating the economy. \__Ref . 2^\

The majority, however, felt that the company was in real danger

of going bankrupt and needed Federal financial assistance in order

to survive. Lockheed's position as a major defense contractor and

also the request of the British government were important factors

to be considered.

Whether Lockheed would have failed if the Senate had rejected

the loan will never really be known. However, several previous

empirical studies have produced some important theories on the

predictability of financial failure. It is the intent of this thesis to

use these former studies as a base and attempt to determine whether

Lockheed was on the path to bankruptcy in the year 1971. Also

10

included will be an similar analysis for the years 1971-1972, since

Lockheed again claimed to face cash problems when financially

troubled Eastern Air Lines asked for a stretched-out delivery schedule

of its ordered L- 101 Is. [kef. 3^

Those previous works that play an important part in this thesis are

two studies by William Beaver in 1966 and 1968 and a study by Paul

Dascher in 1970. Several important observations were gleaned from

these three studies that, their authors claimed, were highly predictive

of failure. Two of these observations were the following:

1. Non-liquid asset ratios predict failure better than liquidasset ratios.

2. Failed firms' ratios tend to deteriorate markedly fromthose of non-failed firms as failure approaches.

These symptoms seemed to fit very well the situation of Lockheed

Aircraft Corporation in the 1966-1970 time-period. Many of Lockheed's

ratios were quite different than those of the rest of the industry-

-

especially the non-liquid asset ratios. These differences seemed to

become more pronounced as 1971 approached. Lockheed's average

ranking by ratios in the industry declined markedly over the period

of this study. It was these main points that led to the conclusion that

Lockheed was headed for failure.

The ratios for 1971 and 1972 show also that Lockheed is below the

industry average. However, these ratios, while low, are not as bad

as they were in 1970. Several of the ratios are in a downward trend.

Nevertheless, while the ratios reflect a dependence on inventory

realization, they still have not degenerated in 1972 to the point where

subsequent bankruptcy is evident.

11

II. HISTORY OF LOCKHEED

Lockheed Aircraft Corporation was incorporated on June 21, 1932.

It succeeded the Lockheed Aircraft Company (incorporated in 1926 in

Delaware), which was to become the heavier-than-air division of the

Detroit Aircraft Corporation. The latter company went bankrupt but

Lockheed lived on. The newly incorporated firm's first successful

plane was the Model 10 "Electra. " More than 150 of these were sold

to domestic and foreign airlines before the start of the Second World

War.

The success of the Electra- 10 didn't end there, however, as

modifications thereto produced the Model 12 and Model 14. One

hundred and fourteen units of the "12" were sold. The Model 14

"Sky Zephyr" was converted to a bomber, and the British initially

bought 200 of these in 1937. The performance of the plane, which

became known as the B-14 "Hudson, " was praised highly by the

British; and they subsequently bought over 1, 000 of them before the

war's end.

Lockheed also introduced the Model 18 "Lodestar" and was working

on the 4-engine "Constellation" in the late thirties, but, as the war

approached, the company's efforts shifted from civilian aviation to

military needs. During the war the company produced 10 per cent of

the total American output of war planes, some 15, 000 units. These

included the P-38 "Lightning, " the "Hudson, " the B-17 "Flying

Fortress, " the "Harpoon, " and the "Ventura PV. "

12

A. WAR'S END TO THE SIXTIES

With the war winding down, Lockheed turned its attention back to

the commercial market and pushed development of a 100-seat passenger

plane it had designed initially for Pan-Am in 1940. This previous work

gave Lockheed an advantage over competition, and the corporation

aggressively marketed the new "Constellation. " (Orville Wright

piloted the plane in a demonstration flight.) I Ref. 4j The "Connie"

became one of the most familiar commercial aircraft ever produced.

The advent of the 'cold war' refocused attention on military aircraft

production, and Lockheed quickly established itself as a leader in

that field with the P-80 "Shooting Star, " the first operational jet

fighter. The P-80 (later the name was changed to the F-80) was mod-

ified to become the T-33 "T-Bird, " and this plane was in turn modified

to become the F-94 "Starfire. " All three were highly regarded

by the military and over 7, 000 of these planes were sold - 800 F-80's,

6, 000T-33's, and 600 F-94's. Another successful post-war plane

was the P2V "Neptune, " used primarily by the Navy for ASW work.

Other profitable ventures in the fifties were the C-130 "Hercules"

and the F-104 "Star- Fighter. " Both were extremely successful and,

although introduced in the early fifties, both are still operational

in 1974.

Contrasting with these notable successed, however, were

several failures. The list includes the "Constitution, " the "Saturn,"

the "Little Dipper, " the "Big Dipper, " and the "Jetstar. " As the

decade came to a close, the successes of the company pushed

Lockheed toward a position of being heavily dependent on the military.

13

The "Constellation" was its only highly successful civilian venture

and, even at that, many were sold to the military.

With this in mind the company attempted to enter the commercial

market (it's first love) |Ref. 5, p. 45_\ with the Electra, a new

passenger plane with the same name as its 1930s' predecessor. It

was a turbo-prop introduced late in the 1950s', just when Lockheed's

competitors were about to deliver the first jet airliners. The Boeing

707 and the Douglas DC 8 swept the Electra and Lockheed from the

commercial airliner market. | Ref . 6, p. 4\ In addition, two well

publicized crashes of the Electra sapped its potential even further.

The Electra experience made the company even more military-

dependent than before.

As Lockheed grew during the fifties, it diversified into other

areas. It set up the Lockheed Missile Systems Division in 1953.

It purchased Puget Sound Bridge and Dry Dock Company in 1959 and

entered the shipbuilding, ship repair and general construction

business.

B. THE SIXTIES

The early years of the decade of the 1960s' were a time of

cold war, response to the Sputnik and increased defense spendings.

The United States was becoming more involved in the Viet Nam War.

Lockheed, being highly military-oriented, was in an excellent

position to take advantage of the path the United States was to follow.

Lockheed was prime contractor for the Polaris missile program

and its follow-on, the Poseidon. Through modification, the commer-

cially disastrous Electra turned into a military profit maker. It

14

became known as the P-3 "Orion", and took over the role of the P-2V

as an ASW patrol plane. The company won contracts for building

destroyer escorts and amphibious assault transports for the Navy.

Also, Lockheed was to build the C5A for the Air Force, the Cheyenne

Helicopter for the Army and the SRAM rocket motor for Boeing Aircraft

Corp. These contracts helped Lockheed become the largest Defense

contractor in the years 1962-1966. (It was #2 in 1961 and 1968 and

#3 in 1967.) Lockheed's good fortune was reflected in its stock price

and its ability to place debentures. JRef. 7\

However, Lockheed did find itself excessively dependent on

military contracts (90% of its sales during the 1960s' were to DOD).

Hence, on May 2, 1967 it disclosed plans that it was exploring three

new commercial ventures. This occured after losing to Boeing in

the bidding for the SST contract. The three programs were a large

frame subsonic passenger jet, a commercial air cargo plane and a

rigid rotor commercial helicopter. j"Ref. 8\ Later that year, the

decision to produce a large passenger jet plane was made and the

L-1011 "Tristar" was born.

1. A Crisis Begins

Troubles were beginning to mount in the late sixties when

problems with several defense contracts became apparent. Costs

were running higher than contracts allowed, and Congressional

criticism of excess defense spending was becoming fashionable.

Four of Lockheed's programs came under sharp scrutiny.

These were the C5A, the Cheyenne Helicopter, the SRAM motor and

several Navy shipbuilding contracts. The first three of these programs

were under "total package" procurement contracts covering both

15

design and production. Secretary of Defense Robert MacNamara had

introduced this contracting concept earlier in the decade. Prior to

the total package concept, DOD would contract for the design phase

of a system and the production phase separately. This usually led

to the winner of the design phase ultimately winning the production

phase, and the total package contract was instituted to overcome a

resultant problem. It was charged that contractors bid exceedingly

low on the design phase in the knowledge that they could cover their

losses on the production phase.

While the total package idea was well meant, Melvin Laird,

Secretary of Defense in the late sixties, rejected it as unworkable.

Contractors said that ultimate costs were impossible to estimate.

Although complex clauses in this type of contract were supposed to

protect both buyer and seller as program changes were made, they

more often led to sharp disagreements. Lockheed claimed that the

total package system had proved virtually unworkable and that

existing contracts should be revised. \R ei - 9j The company also

admitted being overly optimistic in its bidding, however. jRef. 10 I

When Lockheed didn't get what it considered fair payments,

it took its case to the Armed Services Board of Contract Appeals.

However, a decision here would take years and, in the meantime,

the company had to live under the contracts it originally signed.

Lockheed's on-going programs, meanwhile, were causing a tremendous

cash drain. The crisis came to a boil on March 6, 1970, when

Lockheed threatened to stop work on the four programs if it didn't re-

ceive iterim financing. YRef. 9j DOD replied six months later by

proposing a plan in which the Government would provide funds if

16

Lockheed assumed over $480 million in losses and dropped its court

case. At first, Lockheed rejected this proposal and said it would

settle the issue in court. However, it soon became clear that the

company's lack of cash flow, was becoming critical. Also, extension

of a very substantial line of bank credit was contingent upon settlement

of the government disputes. With no other choice available, Lockheed

accepted the government's proposal.

2. L-1011 "Tristar"

The losses on the four defense contracts had ramifications

in other parts of the company as well. Half of the $400 million bank

line of credit that was initially earmarked for the L-1011 airbus

was diverted to cover cash shortages on the defense contracts. [Ref. 6, p. i\

With such internal problems raging, the L-1011 ran into

external troubles as well. It was encountering sharp competition from

both the Boeing 747 and the McDonnell Douglas DC10. Both planes

had beaten Lockheed to the market in the race for customers, although

the 747, with its greater range and capacity, wasn't a direct competitor.

In addition, the rate of growth in air travel started to fall off in the

early seventies; and this hurt the sales of all three "jumbo jet"

manufacturers

.

The biggest blow to Lockheed came when Rolls-Royce, which

was to produce the RB211 engine for the Tristar, declared bankruptcy.

Apparently, Rolls-Royce had bid very low to get the contract against

the stiff competition of General Electric and Pratt & Whitney. The

British Government entered the picture and agreed to stand behind

the operations of Rolls-Royce. However, Lockheed would have to

incur increased costs for the engines - roughly $330 thousand

17

more per engine, or $1 million per plane. The British government

also wanted a guarantee that Lockheed would actually buy all 555

engines.

Since Lockheed's finances were in a precarious position due

to its defense contract disputes, the British wanted the United States

Government to provide assistance to Lockheed. President Nixon on

May 7, 1971 asked Congress for a loan guarantee for Lockheed, and

a heated debate ensued that summer. The company based its claim

for help on the following financial data: JJRef. 11, p. 24-25]

Cash and equivalent (Jan. 1, 1971) $ 79 millionLine of credit remaining $ 50 million

1129" millionNew Cash flow (Jan. -Jun. 1971) $ 20 millionUse of credit remaining ($ 50) million

$ 99 millionNew cash flow (Jul. -Sept. 1971) ($ 91) millionBalance (Sept. 30, 1971) $ 8 millionLockheed's average monthly interest expense $2. 5 millionLockheed's average monthly wages expense $7.0 million

In addition, Lockheed's consortium of creditors said they would

bar any new loans to the company without a government guarantee.

Reasons given by the White House for approval of the bill

(Emergency Loan Guarantee Act) were the threatened unemployment

of 30,000 people, economic losses affecting the U. S. GNP and

California's GNP, complications in other Lockheed defense contracts

(most notably the Trident, the S-3 and the SR-71), and the loss of a

big competitor from the aerospace industry. [_Ref. 11, pp. 32-43J

Reasons brought forth by critics against passage of the bill focused

on the dangers of manipulating the competitive system and the setting

of a bad precedent. 1 Ref. 2 I

18

Ostensibly, the Emergency Loan Guarantee Act was intended

"to provide credit to large, well established and creditworthy

enterprises"; \Ref. 11, p. 3Jbut, in fact, Lockheed was the sole

applicant. Ultimately, the bill was approved by a vote of 49-48 in

the Senate; and the Emergency Loan Board was set up in early August.

This allowed Lockheed an additional $250 million in financing with

which to continue development of its Tristar.

C. THE EARLY SEVENTIES

After the loan guarantee, fiscal years 1972 and 1973 were spent

obtaining orders for the L-1011, filling orders for existing defense

systems, working on the development of new systems for recently

won contracts and drawing down the $250 million loan for v/ork on

the L-1011. By June 30, 1972, Lockheed had used $150 million.

By December 1973 the total guaranteed loans had risen to $200 million.

Sales for the L-1011 were slow because of the drop in the rate

of growth of air travel. In December 1973 Lockheed had kept pace

with its competition with 199 orders and options. McDonnell- Douglas

had 230 orders and options for its DC10. ^Ref. 14, p. A21J Lockheed

had earlier estimated a total market of 1, 325 trijets by 1980, and

it expected to get its share of that potential, j Ref . 15 1

1. A New Crisis

By late 1973, the company claimed again to be in financial

troubles and was looking for further financing, a merger partner,

speed up of L-1011 deliveries, or some combination of the three.

Lockheed's inventory was the only asset on its balance sheet that was

rising substantially, and $959 million of the total $1, 065 million in

19

inventory were associated with the L-1011. YRef. 12, p. 12 Of

this L-1011 inventory, over $137 million were deferred R&D costs

and general and administrative expenses. *

Lockheed reported earnings of $15 million and $16 million in

1971 and 1972 respectively. Development costs which were included

in inventories for the L-1011 in those two years were $82 million

and $55 million respectively. }_Ref. 16J

Obviously, expensing

R&D costs would severely affect Lockheed's earnings.

Also, while Lockheed claimed that, because of fewer models

and a newer plant, its breakeven volume for the L-1011 was 300

planes (as compared to McDonnell- Douglas's estimate of 450 for

its DC10), this low figure was questionable. \Ref. 14, p. A21_\

The company received a qualified opinion on its financial statements

each year since 1970.

* Lockheed isn't the only company which is deferring programdevelopment costs, however. McDonnell- Douglas is deferringsuch costs on the DC10. No other aerospace manufacturer is

deferring development costs, but then no other has a large commercialventure which has not reached the break-even point.

20

III. THE SCOPE AND FOUNDATION OF THE THESIS

The assertion that Lockheed Aircraft Corporation was facing

financial disaster in 1970 made headlines throughout the country and

posed a potentially grave problem for the Department of Defense (DOD).

Lockheed at that time was involved in the production of many weapons

systems for the government. Its ranking as the largest defense

contractor in fiscal years 1962-1966, 1969, and 1970 explain the

reason for DOD's concern.

Lockheed ultimately received a $250 million loan guarantee from

the United States Government. This thesis is an examination into

whether Lockheed was headed for bankruptcy, as its management

claimed. [Ref. 11 Financial ratios will be used exclusively in this

examination.

This is not the first study of its kind. Several empirical studies

have been conducted in an attempt to identify measures which can

forecast the failure of an enterprise. Studies by Paul FitzPatrick,

Arthur Winoker, Raymond Smith, and Charles Merwin all pointed

out correlation between incipient failure and the relative values of

selected financial ratios. I Ref. 18, p. 61] In addition, William

Beaver's two studies in the late 1960's attempted to evaluate the

ability of financial ratios to predict business failures.

A. BEAVER'S STUDIES

In a 1966 study, [Ref. 19J Beaver selected 79 insolvent companies

and individually paired them with 79 solvent firms of similar asset

size within their respective industries. He then performed certain tests

on their ratios. All data used for the ratios were obtained from Moody's

Industrial Manual. ["Ref. 20]'

21

Beaver first compared the means of financial ratios of the failed

companies to those of their unfailed counterparts over a five-year

time period. Using four a priori assumptions, he made predictions

of the results of the paired comparisons of the means. His assumptions

were: {Ref. 19. p. 801

(1) The larger the reservoir of liquid assets, the smallerthe probability of failure.

(2) The larger the net liquid asset flow from operations,the smaller the probability of failure.

(3) The larger the amount of debt outstanding, thegreater the probability of failure.

(4) The larger the expenditures for operations as apercentage of sales, the greater the probabilityof failure.

Beaver selected six ratios on which to base his predictions. This

choice of ratios was made on the basis of popularity in current

literature, strong performance in previous studies, and the growing

importance being given to the funds flow concept. His ratios and

predictions were as follows: [_Ref. 19, p. 81J

RATIO PREDICTION

Funds flow to total debt Nonfailed > FailedNet income to total assets Nonfailed > FailedTotal debt to total assets Failed > NonfailedWorking capital to total assets Nonfailed > FailedCurrent ratio Nonfailed > FailedNo-credit interval Nonfailed > Failed

The actual results confirmed Beaver's predictions.

. . .the difference in the mean values is in the predicted directionfor each ratio for all five years before failure. Failed firmsnot only have a lower cash flow than nonfailed firms but also a

smaller reservoir of liquid assets. Although the failed firmshave less capacity to meet obligations, they tend to incur moredebt than do nonfailed firms. fRei ' I 9 * P« 89J

22

A graph of the means of nonfailed firms versus time before failure

shows that the trend line connecting the plotted points has a zero slope.

Yet, the trend in the means of the failed firms has a marked deterio-

ration and slope. This difference is noticeable five years before

failure. Plotting both the failed and unfailed companies' means on

the same graph shows that the difference in means increases as the

year of failure approaches.

The data demonstrate a substantial degree of consistency.The evidence overwhelmingly suggests that there is a differencein failed and unfailed firms. Since the means used in thiscomparison had a non-normal distribution, however, noconclusion could be drawn from the comparison of themeans. (Ref. 19, p. 81J

Therefore, Beaver then used a dichotomous classification test to

make a prediction of a company's success or failure. In this test,

Beaver arranged all the values of the individual financial ratios in

ascending order. The array was inspected and a separation point was

selected. Beaver then assumed that the means of the failed firms were

on one side of the separation point and those of the unfailed firms on

the other side. This separation point is selected so as to minimize

the percentage of incorrect classifications. He then calculated the

number of misclassifications. That is, if he assumed a firm to be

failed (nonfailed) and it was nonfailed (failed), a mis classification

ensued. The results of the dichotomous classification test approximate

what the mean comparisons had already shown.

The ability to predict failure is strongest in the cash flow to<̂ _

total debt ratio. . .

Clearly all ratios do not predict equally well. The net income to ^total assets ratio predicts second best, which is to be expected since

its correlation with the best ratio is higher than the correlation of

any other ratio with the best ratio. The total debt to total asset ratio

predicted next best, with the three liquid asset ratios performingleast well. jTlef. 19, p. 85-86]

23, .

In a 1968 study, Beaver reported on a continuation of his previous

work. Some conclusions drawn in this report were that the non- liquid ^=~

asset measures predict failure better than the liquid asset measures,

even in the years immediately before failure, and that the two less

frequently advocated liquid asset measures (working capital and cash)

outperform the two frequently advocated ones (current assets and

quick assets). jRef. 21, p. 1 211

B. DASCHER'S STUDY

With Beaver's studies as a starting point, Dascher attempted to

analyze the Perm Central Railroad bankruptcy after the fact. Since

Perm Central had undergone a merger two years before bankruptcy,

data for the study were obtained from the years 1968 and 1969 only.

Dascher based his study on Beaver's results, v/hich suggest that,

when the values of relevant ratios are below established levels, the 4;

company is headed for financial trouble. "The more significant the

difference from acceptable levels, the greater the potential for

failure." [Ref. 18, p.63J

Dascher used the means of the financial ratios of nine other

railroads as the established level. He used the nine other railroads

in the sample to estimate the parameters of a normal distribution.

He then could compute the probability of an observation, at least

as extreme as the Penn Central value, given an observation from the

same normal distribution; this probability is called the level of

significance. j_Ref. 18* P- 63J

The smaller the level of significance,

the higher is the confidence that significant differences do in fact

exist between Penn Central and the industry sample. A low level of

24

significance prevailed. With this information, he concluded that the

Perm Central's failure, in hindsight, was not improbable.

Also in his study, Dascher ranked the relevant ratios of all

the railroads for the two years, and he computed the average of

these rankings. Perm Central's overall rank did improve in 1969

compared with 1968. However, the average of the ranks of the most

important indicators, the non-liquid asset ratios, didn't follow the

overall average and actually were worse in 1969. Penn Central's rank

for the two years was consistently low; only once did any ratio reach

the fifth position or better. Dascher also performed a correlation

coefficient test for the rankings between years 1968 and 1969 and a

high correlation coefficient resulted. These results further support

Dascher's conclusion.

C. THE PRESENT STUDY

The current study is based on the work of both Beaver and

Dascher, but it is closer in format to Dascher's study. The ratios

used by Dascher plus two others (working capital flow /total debt

and net monetary assets flow /total debt) will be employed in this study.

All data used in the computation of the financial ratios were obtained

from Moody's Industrial Manual. A sample of ten aircraft manufactur-

ing firms will comprise the comparative group of this study. A mean

for each ratio of these ten companies will then be compared to the

corresponding ratio of the Lockheed Aircraft Corporation. In

addition, a ranking of the ratios will be performed. The results will

then be viewed for the five-year interval leading up to the emergency

25

loan guarantee in 1971. A similar analysis will also be conducted

for the years 1971-1972, as Lockheed claims that it again faces

financial crises. [Ref. 3J The dichotomous classification test

will not be used because, as in Dascher's study, there is only

one "failed" firm. The significance test that Dascher performed

will be omitted since the assumption of normality does not apply.

26

IV. DATA PRESENTATION

Due to the successful predictive results of Dascher's study [Ref. 18_\

and Beaver's 1968 study [Ref. 21J , the same ratios were chosen

for this analysis with two additional ratios that were deemed appropriate.

As mentioned in a previous chapter, the extra two ratios are the

working capital flow /total debt ratio and the net monetary assets

flow /total debt ratio. The former is defined as the change from

year to year in the difference between current assets and current debt

divided by the total debt of the later year. The latter is defined as

the change in the difference between quick assets and current debt

from one year to the next divided by the total debt of the later year.

Both were chosen because of the increased use being made of

the funds flow concept. The working capital flow /total debt was

specifically added because it was felt that this ratio would more

succinctly demonstrate how the firm was taking on added debt and

also as a comparison to the funds flow from operations /total debt

ratio. The net monetary assets flow /total debt was included in

order to observe how Lockheed's increase in inventory effects the

working capital flow /total debt ratio.

A. FOURTEEN BASIC RATIOS

The financial measures that are used in the calculation of the

remaining fourteen ratios are defined in Table I.

27

Table I

MEASURE DEFINITION

net income total earnings from operations

total assets the sum of all assets acompany owns

total debt both long-term and short-term liabilities of a companyplus certain deferrals (e.g.taxes)

current assets ... those assets which will berealized in one year or oneoperating cycle, whicheveris longer

quick assets current assets minus inventoryand prepaid expenses

current debt those liabilities whose liquida-tion reasonably requires theuse of current assets or othercurrent liabilities

working capital current assets-currentliabilities

cash cash and marketable securities

sales the revenue of a companyduring a specific year

funds flow from operations net income plus depreciationand amortization

The two additional ratios chosen for this study plus the ratios derived

from the Table I measures are as follows

:

Working capital flow /total debtNet monetary assets flow /total debtFunds flow /total debtNet income /total assetsTotal debt/total assetsCurrent assets /total assetsQuick assets /total assetsWorking capital /total assetsCash /total assetsCurrent assets /current debt

Quick assets /current debt

28

#1.#2.

Ul_ #3.fjL #4.

#5.l #6.

u #7.

l- #8.

#9.l #10

#11

L #12. Cash/current debt^#13. Current assets /sales#14. Quick assets /sales

«- #15. Working capital/sales#16. Cash/sales

Ratios #13, #14, #15, and #16 will be collectively called'turnover ratios'.

Beaver, in his 1968 study, categorized the ratios he was using

into liquid asset ratios and non-liquid asset ratios. Liquid asset

ratios are those which are generally regarded as indicators of short-

term solvency. Likewise, non-liquid asset ratios are measures of

long-term solvency. Therefore, Beaver's 14 ratios can be subdivided

into two groups, liquid asset ratios and non-liquid asset ratios,

according to whether they are long or short term predictors. fRef. 21,

p. 114*] Ratios #3, #4, and #5 are non-liquid asset ratios and

ratios #6 thru #16 are liquid asset ratios.

Funds flow from operations /total debt can be viewed as either

liquid or non-liquid. However, since Beaver concluded that this

ratio is a measure of long-term solvency, he listed it as a non-liquid

asset ratio. [Ref. 21, p. 114J As the two added ratios were not

included in earlier studies, they will not be categorized as either

liquid or non- liquid.

B. THE FIRMS IN THE STUDY

The list of firms chosen as the sample to be compared with

Lockheed were those aerospace/defense companies that could be

found in Moody's Industrial Manual. [Ref . 20J The firms are

listed in Table II.

29

Table II

FIRMS

#1. Boeing Company#2. Curtiss -Wright Corporation#3. General Dynamics Corporation#4. Grumann Corporation#5. LTV Aerospace Corporation#6. McDonnell- Douglas Corporation#7. Northrup Corporation#8. Rockwell International Corporation#9. Teledyne, Inc.

#10. United Aircraft Corporation

All financial data used in the analysis come from their financial

statements as listed in Moody's. In the case of LTV Aerospace,

data were not presented for 1971 and 1972. In the case of Rockwell

International, consolidated statements for the years 1966 and 1967 weren't

given and, therefore, the company wasn't included in the calculations

of those years.

All firms are principally involved in the aerospace industry. Some

produce a whole airframe. Some produce only parts of an airframe.

In the former group are Boeing, General Dynamics, Grumann, LTV

Aerospace, McDonnell- Douglas, Northrup, Rockwell International,

and United Aircraft, in addition to Lockheed. In the latter group

are Curtiss -Wright and Teledyne.

Several companies have diversified into other fields, but still

a major portion of each selectee's business is in aviation construction;

and all sell to the Department of Defense. Since the sample includes

only ten firms which were not randomly selected and since there is

only a small population, the assumption of normality cannot be made.

Unlike Dascher's, this study will not use statistical methods based

on the assumption of normality.

30

C. DATA

Financial data for all of the firms used in the study are listed in

Appendix A. With these data, the ratios were calculated for each com-

pany and are included in Appendix B. The means and standard deviations

of the financial ratios for the ten comparative firms and the comparable

ratios for Lockheed are also reported in Appendix B. All the financial

ratios are graphed by year in histogram form with the mean and stan-

dard deviation included. Lockheed's position is indicated by a delta (A).

These histograms are displayed below in Figures 1 thru 16. The

histograms for each ratio are arranged so that the successive means of

the ten comparative companies are aligned vertically. Histograms for

the five years preceding the loan guarantee (1966-1970) appear on the

left side of each figure and those for 1970 plus the two years after the

loan guarantee appear on the right side. The histogram for 1970 is

repeated in order to depict graphically the effect that the loan may have

had on the ratios of the subsequent two years. The means of the

financial ratios of the industry are then compared to Lockheed's

financial ratios in graphic form (Figures 17 thru 32).

The eleven firms were ranked according to their respective values

for each of the sixteen ratios for each year in the study. In each case,

the highest ranking indicates the most favorable ratio value and the

lowest ranking, the weakest value for that ratio. There are eleven

places in the ranking for 1968, 1969, and 1970. In 1966 and 1967 and

again in 1971 and 1972, however, there are only ten places because of

the absence of data for Rockwell International and LTV Aerospace, as

explained above. Table III shows Lockheed's ranking by each ratio in

each year. It also shows Lockheed's rank according to the average

ranking for all ratios and for the three non-liquid asset ratios.

31

4

/US a

i

7

£

3

/

Ratio #1 Working Capital Flow /Total Debt

Figure 1

-I o ,/ .1 3 w .5"

-.( o •' .A -3 .V

-A-./ o .» A -1

/ I n-j-i o / .»

s

H

/17/3

^/

ft

-A- / o . 1 .3^

6

5 14m 3

.?

i &

-A-. / <3 . / .3.

-/ ° ./ ,z

mo 3

i

-*-.i o ./ .a

32

I V

Ratio #2 Net Monetary Assets Flow /Total Debt

Figure 2

3

a

Z3-j^-A -j£ -rf -& o

tai .1 .lOojt

1*1 /

I

'JS'-.A- - *" -.1 •» O .cS",V .^ ,»'

A->

/ft?I'/ J

1

-X' »--,IS-

-. 1' e?"

1"

flf.1 • *.»l

1

3P

,tf -,\ -<£ ,«S.| jS J">

1171 n-^^ -tf-* -tf? o ,«£ ,1 .\* .3 j$

3

H--36'-»-j5'^ -.«»' a fi£ <' .\£ o~

m\H

3

/ r^ -J -,#-> "/* of .rf .1 .p .r

13

H7o3l1 r—r—

A-4— J*f

~>r/ -.rf o .o-O .(^

33

Ratio #3 Funds Flow /Total Debt

Figure 3

&*0 ,<Hrf,i>,it,i ,sn ,x.mi>-+Wo

43

**J*l ,o4 .0*> ,? A*» .* & >* >* .^."^

r1 ' a.^o^f .08 .la.ie .*-.av.a?-3A.3 6

3/ft* 2*

tn•£H o .Of.OS .19*. lb .9. .AH .Ja.3x.3e

7

/^ ' g_ h ID

:of o AH j&.i3..ib .?-.ai/ .ay.3a..3<,

fj

3

'3.

-oV .0 .c* .«8 .1* ifc.a. .a.1 .a? .33L.3&.

n' a rra n

-:oS o r*«f-«8 '*-'* >. .X.V .3ky.ii.3>»

mo 5

'_&t-

34< \

Ratio #4 Net Income /Total Assets

Figure 4

If

2.

/

"0> O *>* ^ .6^ o* .\

/97b

&

-.oV -.<rt-.<* o .o5 *4 ,ot> .oft

t r- •

5

/%7 3

a Ai n

O .©* 0f ^3£> .6?

L ' t— - •- —]

6

Mfl& 3

<2

1&

J97I

H 11

3A

/ A

.*)

i

4,o«.

J<P2 a-^-cj^ c> •£>* .oW Ofc eg

-,o* © .ca.of.ofa .08

m3

I I—

I

1 1 ,

-;offT<3a. o .<A.cy/.ofa.oS

tVo

3

1

/ —

1

1 -4—

Tofo'oH ".o* °tO> .oH .ote ^J?

35\

Ratio #5 Total Debt /Total Assets

Figure 5

5

a

KfU n.*.3.V .£,<*.! ,?

/?10

2>

2

4-A

^-.3 /f .«T.b .7 .8" .<?

5A

/

.a ,3 .4 .5" .6 ,7 .? .?

n«

b

6A

2,

aT—

/

—

i

&

.3^.3 ,4 .5 -t .7 .S .7

liti

3

a rQ

.a .3 .¥ -5 .b .7 .? ,?

moA

4- &.A 3 .*/ .S' > 7 % ,<)

3a

.ft -3.M .5-,fe ,7 ,ff .9

3

n,*.*.** .^.t 7 .8 .<?

36

Ratio #6 Current Assets /Total Assets

Figure 6

/%£>5

D>(> ^.in^^-^n

/

JZL Dg& •t .^ •7 .75".« .scf,^ £

H nr 1

3w1 A

.r,«3\t, .4 if ;7 .-tf",* .«"/}

Md$& .<<, ,«r .7 .>".? .«£

1 970

3

£I

1

\ &£& .(. A£.'7 /JOi\<&"3

mo3<3

a..4 .-tf .5 .# > .*> 1 .tf .« ,?^

3

ml/

*#/ ^.tW 7 ,7*"*

lt"Wa

•/£,* 5S .4, .t^.7 /7S.SX

37'

Ratio #7 Quick Assets /Total Assets

Figure 7

T3

fltfc *1

ZL,tf £ j^ > ,3^ <i* .£ ,*6 ,t

1%1

5

A/

1 1

\<O ^';i ,i>*vM€£

m,

Ksd n

.1? .a«a£3.3£"tf .^.5" ^5

pei

ii,15".* .35" ,3, aj-.S ,^,X 45"

\°cb

&F& &

»

*-# .3, 3$ > .56 t\ AS .• .65

IT70

36*

t>1-

1

1971 > £

^^.>^T £ 3^,4 .4*

V

i<m

«^ir ,> .-** 3 as * x,^^

38

Ratio #8 Working Capital/Total Assets

Figure 8

H3aM l nut n

.\ & > ,.aO 35 A m4.*

1%1i

.1 ,t£,% ,3JS"3 2^.4 i\6$

%®' H D h

,^,31^.3 3?f.4 .*?

3

I

±,| .l^AX3,!f

l<*7o

53k

2s.

I A6 .* .is' ,»>.*> ,H

/77D

3<3

l<?7/

5

/

ni2 s

I

3..1 .\$>&2>?aH

£ .itf&tf.+ .V

d,1 ,\6>.76A ,4S»t ,^.5-

39

Ratio #9 Cash/Total Assets

Figure 9

3

a

_@.ol o* <&>&* -ctf.ot.fl .at"

/

a ^of .cS ,<*3 of oS" Ab .o7 ,a?

tfk?

6"

3

n/3>l .63- .03 of AS .ofc p7

/<Ho

3

•a°P/^>-tBC*V .O-S'/Ofc 07 O?

4 r-T3

/<n/ 5/

I x» .63 . of .to ^) 6 ,(37

5

^TT^ 0/ p3..c>3 PH ,o«"pfc pn ot

ml5<3

&r>f .<a .03 pf ,05- jot, ^7

tf70 4I &

O .01 AS ,ci oH .co ,Cb ,ca .0?

401 \

Ratio #10 Current Assets /Current Debt

Figure 10

to

M3

a

/ r- *i—1—

1

L_

IA /.•* Ut |£ a© ax** at iS ?>o

/970

3 rn

/

19-LH l.fc 1^5.0 jj-^a.4. JSBO

WA

/.0|.> M 1.6 |.% M>*-±3H 3-<°& S-o

\%%

3

A1 |—

i

aIfil *i .H 1

1

3

/ &

u» /.Ml.fc U^-Oj.s-^a.fe

mi Q—

,"* r1* M I* '•* AO SL3-5/4J.4 A^ 3.0

TO/.J- w it ijrj.o^a^-zc

/970

3

I

i_a H i.t /.% aJo3.a-j.'< at a* s<

41

Ratio #11 Quick Assets /Current Debt

Figure 11

in

H3A/ D

,2 .4 L * [.oi>itiit> /.**>**|

3

IVo ,

•a. H £ ,r i.o i.7- i.i

\%1

3 —

/ n nA ,H U .% 1.6 t*. \.H /Jo I* 3d22-

mi i £A M ,le X to j.z-tM- \.L /£

3

3

W /

.*.*f U ,* t.oi>iA\t> Mrjo

.A ,^ ,t .? ,.© ,.> /w

.=3

n n«? .4 .i ,? /.o /5/.ty l,U.»<5.o

3

/

•3 .4 .C .<* I.o |.3L |.4

42i \

Ratio #12 Cash/Current Debt

Figure 12

\%(o

H3

5!

© <fl .«> .oS,\ .*» .ft ,ib j* ,^

3

l%7;

4

I

— L

A^.d? pS ,/o v>.H Jt .is

r E?,<** ,c6 p% ,\0 ,i> .ft .It ,\6 ,»**!

197O

.2

/

r: n/P-.eM .Ot .« ,|£> lf

»- ^ ,ib A«g y>%

mi i*1

Z^.ofo X?? ,1° ,/a- J*4 AU J* -io

ma i

&>tA (* t&.\ .1^.1 4 .lb ,|?

^^>

3Ml 3

/

-#,*- ^A fib ,c£ , to AV ,f4 . |4.

/?70 / £«> «*.y

.

*ik°

.

v.\* . >» »* .

>°

.

>*

43

1

a

Ratio #13 Current Assets /Sales

Figure 13

S

mo i

O- £ .3 3$ .f ,<&5 jf.L Un^>

\%1 £DJ-j&.s.is-h >x £ ,&>± .(J.?*

l%*

3A

.%&

.A^r.3 .ss-/j .^.s-.sr,!. ,tr,7"^

/%*?/

3

1970^

/

.a.,^"^ at.4 *tft£'.s?.i9 ,^,7

A—

+

.jT,i .K A .45" .5 .S5-

.<. ,<.*".

7

44

fe

.3^3 .i5"W -H5"^ ^ST.t, AS^.7

/?7/

3&

^A .^«-,f f^",^^ ,fo

mo.

6H39-

I au^A HS.S- ^fi'.t . t<5-.

i \

Ratio #14 Quick Assets /Sales

Figure 14

3

toMo L*.O^.fD ./O & £ .^.4 HO5*

3

I

J3^ i _ .

^*0S./O .p.» .35" .3 .3^ .4 .vf^

/%%

39- r—

n c.0^ .1 .kT.3- pr.3 -S5->i .Mi" ^r^j

II tf)

9-

&-+

.fli"^ .//> & ,$ ,a/.<

9-

W70 / ri.o .es'.l X .>.*s-.-i ,3S-.^

117/

3<9

n.os. I ^.a- .dtf'.SjV/J ,^

Ivas

I

-j D.O ,o£ -I .ir.> .^",5 ££.4 ,H& S4>

\

cno\

6 .o^ A .\£ .a. ^ .s ,tf A

45

Ratio #15 Working Capital/Sales

Figure 15

3

•»»\

.4o« .O ,(k .} >t >* ,**% .•*-*

tf70

33

nirtjAjp.jk .» -a* *

IM<P

0-,«H .os .i> .«, .» pf.»ai 3?-* -4"*i

iq^

s

'e& >g? .IV.JW .V .aM >? 33-.% -Ho^

5

!

3

I

.<* -«=< . 10- .M. ,».JH .^a

5 —ma 2

y Ml In>M a* ,2^- at .H

flW /fc.

4-,4 ,o<,i> jt > .a>/ -»« ,3> ^6

3

h

& jA A> Ate > .9*1 ,3s-

46I

3a

& -+-**/ *° o^ c^ n̂ <?^ ^^o' .O .«> C

wt>

x$6 p\t> ,od £» ,a»4 ,«* &£pH &6

Ratio #16 Cash /Sales

Figure 16

3Q

I9T0 /

H1911 3

/

\<\&

35l

f r n d© po^pl p&p>.o*£ .o^^ f>« pV.f^^

m3

/ £11<*>£',*t .d^/jv c£ (&{>£ /fl ft? p>

Q,*£ fi. fP &>-<?* 6* <p£ {* <#£&-**

P» ^o*f>6<? <^ C* ^ °*

aiT7a / &1

«i» f 'f^f•*jT,i»«*J<9•** »^

|97D<5

> 1<> Jp r$> V j>

.rf

rfrffffi!> ,©

47i \

Ratio #1

Working Capital Flow /Total Debt

Figure 17

Ratio #2

Net Monetary Assets Flow /Total DebtFigure 18

tt> £7 &S tt lo ~7l

£t> \ol L* I? 7o 7/

LocKKpeo — •

Ratio #3Funds Flow /Total Debt

Figure 19

Ratio #4Net Income /Total Assets

Figure 20

W ^ lb 7' "7*

48

Ratio #5Total Debt /Total Assets

Figure 21

Ratio #6Current Assets /Total Assets

Figure 22

K> 67 & tf) n \ -7>

70 -7/ 7>

/.ocKMheD

/WOosTAY «£M *

Ratio #7Quick Assets /Total Assets

Figure 23

Ratio #8Working Capital /Total Assets

Figure 24

& 67 4« # 7° 7/ 7>" & G7 U # 70 71 y^

49

Ratio #9Cash/Total Assets

Figure 25

Ratio #10Current Assets /Current Debt

Figure 26

CQC

0*

K>

4 « k« <.<? 7o 1/

^DUSTRV MCtW

Ratio #11Quick Assets /Current Debt

Figure 27

Ratio #12Cash /Current Debt

Figure 28

w ul fc« t*1 10 71 7>-

.11.

.14

.P

41

.10

•o?

.07

.of

-

x V

1 r1 A

1 /

1/

1

I

£6 *7 <« if 7o 7/ 7>

50

Ratio #13Current Assets /Sales

Figure 29

Ratio #14Quick Assets /Sales

Figure 30

SXt

lb w fc* tf io v y>

Jo

\

fcfc ^7 U « to II 7d-

LocKv4^eD

Ratio #15Working Capital /Sales

Figure 31

Ratio #16Cash/SalesFigure 32

yi & tf? -70 7/ 7>- ££ 67

51

Table III

Rankings of Lockheed by Ratios

1966 1967#1 WorkingCapital Flow/Total Debt#2 Net Monetary-Assets Flow/Total Debt#3 Funds Flow/Total Debt#4 Net Income/Total Assets#5 Total Debt/Total Assets#6 CurrentAssets /TotalAssets#7 Quick Assets/Total Assets#8 WorkingCapital /TotalAssets#9 Cash/TotalAssets#10 CurrentAssets /CurrentDebt#11 QuickAs sets /CurrentDebt#12 Cash/Current Debt#13 CurrentAssets /Sales#14 QuickAssets /Sales#15 WorkingCapital/Sales#16 Cash/Sales

1968 1969 1970 1971 1972

2

4

3

4

2

3

4

6

3

7

2

5

4

3

10

8

7

6

5

3

3

7

7

5

9

3

4

3

2

10

10

11

11

3

8

6

4

7

6

6

4

5

6

9

11

11

10

3

8

1

7

8

8

3

3

5

2

1

7

7

6

10

1

7

1

2

7

3

5

2

6

3

8

9

10

1

7

1

3

8

4

S

2

8

Overall Average 4. 68Average forNon- LiquidAsset Ratios 3.

3. 68

3.67

5.56

6.0

6.62

10.67

5.93

10.67

4.56

7.33

5.37

9.0

52

V. ANALYSIS AND CONCLUSIONS

Beaver's two studies and Dascher's study were the principal building

blocks upon which this thesis was based. All three works have shown

evidence that the non-liquid asset ratios were the best predictors of

long-term solvency. Beaver's 1966 study and the Dascher study

point out that failed firms' non-liquid asset ratios, if observed several

years before failure, tend toward a less favorable position when compared

with non-failed firms. An alternate way to detect a degerating position

is by observing a firm's ratio ranking. Dascher's work mentions that

a failed company's average ratio rank worsens as the year of failure

approaches.

A. 1966-1970

All of these symptoms, which have been shown to be highly

predictive, were evident in Lockheed's situation as 1971 drew near.

Accordingly, Lockheed was a likely candidate for bankruptcy in 1971.

1. Non-liquid Asset Ratios

While an analysis of most ratios supports a prediction of

bankruptcy, the three non-liquid asset ratios clearly demonstrate

this likelihood. In all three non-liquid asset ratios, Lockheed is

below the industry mean in 1970. This supports Beaver's hypothesis

of the non-liquid asset ratios being better indicators of long-term

insolvency than liquid asset ratios. With regard to the working

capital flow /total debt ratio (ratio #1), Lockheed had one bad year,

1968, and improved in all of the other years. In fact, the company is

below the industry mean in 1966 and 1968 only. However, when

53

comparing this ratio to the other two funds flow ratios (ratios #2 and

#3), certain phenomena become obvious.

In comparing the working capital flow /total debt ratio to funds

flow from operations /total debt (ratio #3), it can be seen that most

of Lockheed's working capital flow comes from sources other than

operations. In Lockheed's case that source is primarily borrowing.

Also, in comparing working capital flow /total debt to the net monetary

assets flow /total debt ratio (ratio #2), it can be seen that a large

portion of the increase in working capital is being invested in inventory.

Lockheed's L-1011 inventory account in 1970 accounted for over

65 per cent of its total net inventory compared with less than 60 per

cent in 1969. Jjtef. 22, p. 28J

This L-1011 inventory's realization is so questionable that it

was one of the principal causes for the company receiving a qualified

opinion on its financial reports in 1969 and a disclaimer of opinion

in 1970. (Subsequent to the loan guarantee approval, Lockheed

received a supplemental report on 1970 from its auditors, Arthur

Young & Company, in which they expressed a qualified opinion.

fRef. 22, p. 26] )

2. Liquid Asset Ratios

The liquid asset ratios further support the findings of the

non-liquid asset ratios.

a. Liquid Asset/Total Asset Ratios

The liquid assets /total assets ratios (ratios #6, #7, #8, and

#9) show Lockheed's current assets /total assets ratio and working

capital/total assets ratio improving, while its quick assets /total assets

ratio is declining. This comparison again shows the growth of the

54

inventory account. The cash/total assets ratio appears to show no

real trend. This is explained in that the cash is being supplied by

long-term debt to supplement weak earnings. With total assets so

greatly outweighing cash and with borrowing readily available to

keep the cash account steady, it would take a large increase in total

assets to decrease the ratio. For example, in 1968, Lockheed had

total assets of approximately $937 million and cash of roughly $2 8

million. The ratio was, thus, .03. In order to increase the value

of the ratio, say to . 04, and increase of cash of only $10 million

is needed if total assets are kept constant. Conversely, in order

to increase the ratio to .04 with cash kept constant, a decrease in

total assets of $237 million is needed. A large rise in borrowing

with an accompanying increase in total assets needs only a small

increase in cash to maintain a given ratio. (This assumes a year of

no profit and no stock transactions.) Thus, the cash/total assets

ratio isn't very meaningful when a company has a low cash /total assets

ratio and ready availability to borrowings,

b. Liquid Asset/Current Debt Ratios

The liquid asset/current debt ratios (ratios #10, #11 and

#12) show many of the same facts that the liquid asset/total assets

ratios do. That is Lockheed is depending on the realization of its

inventory account. More specifically, Lockheed is hoping to meet

current obligations with current assets that are becoming more and

more comprised of inventory. Lockheed's current assets are improving

relative to current debt, but the current assets are internally shifting

from highly realizable cash and accounts receivable to the not-so-

realizable inventory. This can be seen by the degradation of the

55

quick ratio over time. The cash/current debt ratio is somewhat

meaningless because of the same reasons set forth in the last paragraph.

In fact, in this case, the numerator could be increased by long-term

borrowing and the borrowing transaction would not even affect the

denominator. This ratio, like the cash/total assets ratio, is

meaningless.

c. Turnover Ratios

Quick assets /sales (ratio #14), while not improving, constant-

ly outperforms the industry mean. Lockheed, having over 90 per cent

of its sales to DOD, has many government accounts receivable. These

are usually paid promptly. Hence, the favorable ratio results. When

Lockheed's slow turning inventory is included, however, the current

asset/sales and working capital/sales ratios (ratios #13 and #14)

worsen dramatically with time. This points out Lockheed's dependence

on ultimate realization of its inventories. The cash /sales ratio also

becomes worse with time, except in 1971; but, like the other ratios

with cash in the numerators, the value of this one is questionable also.

3. Rankings

Another way to look at solvency is to compare the yearly ratio

rankings. Lockheed's average ranking for all ratios fell from 4. 68

in 1966 to 5.93 in 1970. Moreover, its average ranking by Beaver's

three non-liquid asset ratios declines spectacularly from 3.0 in 1966

to 10. 66 in 1970. It should be noted that only ten firms were included

in 1966 and 11 firms were included in 1970. Still, the decline is

striking. The ranking by the two added ratios (ratios #1 and #2) gives

interesting results. The working capital flow /total debt ratio (ratio #1)

increases from position 6 to position 1, rather than decreasing.

56i

However, when the effect of a rising inventory is eliminated in the

net monetary assets flow /total debt ratio (ratio #2), the rank

deteriorates from position 7 to position 9. This comparison of ratios

#1 and #2 again shows Lockheed's dependence on inventory realization

and L-1011 sales.

4. Conclusion of Thesis for Years 1966-1970

Lockheed was very probably headed toward bankruptcy in 1971.

Not only was it out of cash (page 18), but many of its ratios had been

deteriorating for five years. The non-liquid asset ratios especially

show this degeneration. The only thing that prevents many of the

liquid ratios from hovering near the bottom is the inventory account,

which is carried on Lockheed's books at cost. (As is customary in

the industry, inventory is carried at the lower of cost or net realizable

value. Lockheed has stated that the cost is not in excess of estimated

realizable value.) With the decline in L-1011 sales, however, the

realization of those inventories is highly questionable.

Lockheed claimed it would fail without the loan guarantee. The

CPA firm of Arthur Young & Company refused to issue an opinion on

Lockheed's 1970 financial statements. With the guarantee, Arthur

Young & Company did grant a qualified opinion. Apparently, they felt

that the loan was necessary for Lockheed's survival.

This analysis of Lockheed shows a deterioration in many of

the financial ratios (especially the non-liquid asset ratios) as 1971

approaches. In addition, the position of Lockheed's ratios in an

industry ranking (again, especially the non-liquid ratios) deteriorates

as 1971 draws near. In the three papers upon which this thesis is

based, such occurrences have been found to be highly predictive of

571

failure. The findings of this thesis tend to corroborate the allegation

by Lockheed's management that Lockheed was heading for bankruptcy

in 1971.

B. 1971-1972

Although Lockheed had received the loan guarantee, it claimed

to be heading for another financial crisis in late 1973. This was

brought about mainly when financially troubled Eastern Air Lines

delayed its scheduled acceptance of several L-lOlls. Slack sales

hurt the company also.

1. Non- liquid Asset Ratios

With the loan guarantee in 1971, many of Lockheed's financial

ratios received a vital lift. Two of Beaver's non- liquid asset ratios --

funds flow from operations /total debt (ratio #3) and net income /total

assets (ratio #4)--showed vast improvement. However, the funds

flow from operations /total debt ratio was still below the industry mean

and total debt /total assets (ratio #5) understandably continued to

worsen. Lockheed slightly exceeded the industry mean with the remain-

ing funds flow ratios (ratios #1 and #2). This is explained by the fact

that Lockheed's increased borrowings supported its working capital.

(Lockheed borrowed $125 million in 1971 and $55 million in 1972.)

2. Liquid Asset Ratios

The trends established in the previous five years generally

continued with regard to the liquid asset ratios. The ratios with

inventory in the numerator (ratios #6, #8, #10, #13, and #15) showed

a continued improvement, and most of the ratios without inventory in

the numerator displayed a continual downward trend. The one

notable exception in the latter category was the quick assets /sales

58

ratio, which continued to exceed the industry average. It too, however,

showed a decrease. This decrease was due mostly to the decreased

dependency on DOD. In 1971, 92 per cent of Lockheed's sales were

to the Defense Department, while only 74 per cent of 1972's sales

were to DOD. [kef. 12, p. 2_)

3. Rankings

After an initial lift from 5. 93 in 1970 to 4. 56 in 1971, Lockheed's

average ranking for all ratios again deteriorated in 1972 to a rank of

5.37. (It should be noted that 11 firms were in the sample in 1970

and only ten in 1971 and 1972.) Likewise, Lockheed's average rank

for the non-liquid asset ratios rises from 10. 67 in 1970 to 7. 33 in

1971, but the rank drops again to 9. in 1972.

4. Conclusions of the Thesis for Years 1971-1972

Again, Lockheed's problem lies in its increased inventory

account and slow sales of the Tristar. In 1972 over 50 per cent of its

total assets and over 70 per cent of its current assets were L-1011

inventories. The company had only 176 orders and options at the end

of 1972 and, of these, only 17 were actually delivered. This is still

far from an alleged breakeven point of 300. That breakeven point,

itself, is considered highly optimistic.

Lockheed's financial ratios show its increased dependence on

realization of its inventories. In order to improve the ratios,

therefore, this inventory must be realized and sales must be increased.

With sales of the basic L-1011 drying up, the company has explored

Textron Corporation in May 1974 was willing to invest substantialequity capital in Lockheed Aircraft Corporation. This investment,however, was contingent upon Lockheed improving its financial positionby obtaining 45 more firm orders of the L-1011 "Tristar" by November 1974.

59

the possibility of developing an extended-range version (L-1011-2) to

boost sales. It would have a range of 6300 miles instead of the basic

model's 3300 miles. [R ei « 23, p. 101 However, it will encounter

competition from both the extended- range DC- 10-30 and the jumbo

Boeing 747. To complicate matters further, Lockheed's basic L-1011

can't extend its range significantly without major engineering changes.

In contrast, the DC- 10 can be extended with only minor modifications

and, hence, much lower costs. Lockheed's current cash position will

not support a very heavy outlay of funds. Hence, to compete effectively

with the lower-cost DC- 10-30, the company must increase sales

substantially. [kef. 24, p. 23^

Another source of sales could be in what the firm calls the

L-1011-1. This version would require only small modifications but

would have only a 4500 mile range. IRef. 25, p. 4 \

Lockheed's future is highly uncertain, and its financial ratios

are heading again in the unfavorable direction. Nevertheless, the

company is not facing financial disaster as it was in 1970. Unlike

the last time, it has not claimed it was approaching bankruptcy and

Arthur Young & Company does express an opinion, albeit a qualified

opinion. While the values of the ratios and rankings are not the most

enviable, it would be premature to suggest Lockheed is again facing

bankruptcy. Its ratios merit constant scrutiny in the future, however,

as Lockheed is indeed in a vulnerable position.

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LIST OF REFERENCES

1. "Lockheed Says Bankruptcy Will Be Forced on It if It Can'tGet Enough L-1011 Funds, " Wall Street Journal, May 19, 1971,p. 4.

2. "Senate Votes Lockheed Aid, 49-48; $250 Million, MeasureIs Nixon Victory, " Wall Street Journal, August 3, 1971, p. 3.

3. "Lockheed in New Crisis, to Consider Merger; Seeks MoreCredit, Retains Investment Firm, " Wall Street Journal,December 17, 1973, p. 28.

4. "Orville Wright Pilots The New "Constellation' ," New York

Times, April 27, 1944, p. 10.

5. Wilson, Gill, "Lockheed-Industrial Giant of the Air Age, "

Flying, April 1960, pp. 44-48, 100-106.

6. "Lockheed Aircraft Corporation, Case A, " unpublished, NavalPostgraduate School, Monterey, California.

7. "Lockheed $125 Million Debenture Sold Out at Par; Issue LaterSells at a Premium, " Wall Street Journal , March 22, 1967,

p. 24.

8. "Lockheed Predicts '67 Sales Rise, Holds Off on Forecast of

Net, " Wall Street Journal, May 3, 1967, p. 28.

9. "Lockheed to Stop 4 Pentagon Jobs Unless It Gets Interim$600 Million, " Wall Street Journal, March 6, 1970, p. 3.

10. "Lockheed's Chairman Concedes Firm Erred in Bid for C5AWork, " Wall Street Journal, June 5, 1969, p. 14.

11. Emergency Loan Guarantee Board, "First Annual Report,"

July 1972.

12. "Lockheed's Annual Report for Year 1972."

13. "Lockheed Banks Assert They'll Bar New Loans Without U.S.Backing, " Wall Street Journal, June 15, 1971, p. 15.

14. Standard & Poor's Corporation, "Standard & Poor's IndustrySurvey, " December 6, 1973.

15. "Lockheed Sees Need for 1375 Big Trijets in World Through1980, " Wall Street Journal, May 26, 1971, p. 28.

16. Securities & Exchange Commission, "Lockheed's 10-K Formfor 1971.

"

76

17. Securities & Exchange Commission, "Lockheed's 10-K Formfor 1972.

"

18. Dascher, Paul E. , "The Penn Central Revisited: A PredictableSituation, " The Financial Analysts Journal, March-April1972, p. 61-64.

19. Beaver, William, "Financial Ratios as Predictors of Failure, "

Empirical Research in Accounting: Selected Studies, 1966,"Supplement to Vol. 4 of the Journal of Accounting Research,pp. 71-111.

20. Moody's Investors' Service, "Moody's Industrial Manual,"

Years 1966, 1968, 1970, 1971, and 1972.

21. Beaver, William, "Alternative Accounting Measures asPredictors of Failure, " The Accounting Review, January 1968,

pp. 113-122.

22. "Lockheed's Annual Report for Year 1970."

23. "Lockheed's Annual Report for Year 1969."

24. "Lockheed Needs a Place to Land, " Business Week, July 11,

1970, p. 23-24.

25. "Lockheed's Annual Report for Year 1973."

26. Wilson, Gill, "Lockheed-Industrial Giant of the Air Age, "

Flying, March 1960, pp. 25-27, 87-92.

27. Wilson, Gill, "Lockheed-Industrial Giant of the Air Age, "

Flying, May 1960, pp. 42-45, 97-102.

28. Emergency Loan Guarantee Board, "Second Annual Report,"

July 1973.

29. "Lockheed Plans Huge Writedown of Its 'Tristar', " WallStreet Journal, June 3, 1974, p. 3.

30. "Lockheed Financial Restructuring May Be Upset by TextronProviso, " Wall Street Journal, June 4, 1974, p. 3.

77

INITIAL DISTRIBUTION LISTNo. Copies

1. Defense Documentation Center 2

Cameron StationAlexandria, Virginia 22314

2. Library, Code 0212 2

Naval Postgraduate SchoolMonterey, California 93940

.

3. Department Chairman, Code 55 1

Department of Operations Research &Applied Science

Naval Postgraduate SchoolMonterey, California 93940

4. Professor James Fremgen, Code 55 Fm (thesis advisor) 1

Department of Operations Research &Applied Science

Naval Postgraduate SchoolMonterey, California 93940

5. Professor Harold Larson, Code 55 La (second reader) 1

Department of Operations Research &Applied Science

Naval Postgraduate SchoolMonterey, California 93940

6. LT Edward Bannat, USN (student) 1

Longwood RoadOak Ridge, New Jersey 07438

78

Thesi s

32135c.l

1522^8Bannat

An investigation of s^Lockheed's solvency byuse of financial ratios.

th»iB2136

An investigation of Lockheed's solvency

3 2768 002 01385 6DUDLEY KNOX LIBRARY