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INTRODUCTION & COMPANY INFORMATION

Every industry in the world has been in a period of recovery since the 2008-09 global recession. The airline industry is no exception it is among the few fairly competitive industries that have been unable to bounce back after a long period of indecisiveness and insecurity. The following is a report on the financial situation of the Canadian airline company, Air Canada. We will discuss the advantages and disadvantages of the company in particularly the stock growth and industry averages comparison along with a detailed analysis of its financial statements from previous years as well as current year announcements. If they were following proper guidelines and in an advantageous position compared to the rest of the industry, we would recommend investing in Air Canada. Air Canada is the largest airline company and also the flag bearer of Canada. Founded in 1936 by the federal government under the administration of Prime Minister William Lyon Mackenzie King, it began as a link between the Atlantic and Pacific areas of the country. Today, its main business activity consists of scheduling and transporting passengers and cargo generating revenues upwards of $11 billion. It trades under AC.B and AC.A on the TSX for domestic buyers and foreign buyers respectively. At the same time, it also has a loyalty-marking program (i.e. frequent flier program) promoted through its own brand, Aeroplan. With its headquarters in Montreal, it started as a crown corporation, under the name of Trans-Canada Airlines, before privatizing in the 80s when the Canadian airline industry began deregulating. A decade later, along with a few other international airlines, it founded the world's first and largest global airline alliance, Star Alliance. In 2003, it filed for bankruptcy protection after acquiring their main competitor Canadian Alliance. Shortly afterwards, it was acquired by the Montrealbased holding company ACE Aviation Holdings Inc. In Canada, its major competitors are WestJet, Canjet, Transat, and Porter Airlines all of which are very recent new airline companies whose goal is to attract a large market share by

Page 2 of 13 offering cheaper alternatives, limited by the destinations that they offer (usually only domestic). However, that does not include the other North American airlines that it competes with on an international scale such as United Airlines and American Airlines. Following the global recession of 2008-09, the airline industry has slowed down very much. Earlier this year, the credit ratings company Moodys downgraded Air Canadas rating stating risk of Air Canada filing for a second bankruptcy. As with many other competitors, the current issue for Air Canada is focusing on taking back the market share from the new smaller airlines.

STOCK ANALYSIS
By taking a look at Air Canadas stock prices over the past five years, we can see that there was a large fall in the 2008 fiscal year. From there on however, there was a steady growth trend for the following years. The fall in 2008 was due in large part to the economic crisis in North America. Since then, Air Canadas stock prices have fluctuated around 2$ per share. (Refer to Graph 1, Stock Market Analysis) With exception to the 2008 fall in value, the fluctuation of prices has decreasingly remained steady over the past five years making Air Canada a less volatile stock. In their 2008 fourth quarter news release, (Air Canada , Fourth Quarter Results, 2008) the company explained this decline. It stated that although the decline was due to the worsening global economy and the economic crisis, the unprecedented volatility in fuel prices and the significant fluctuations in foreign exchange also played major roles. The fuel costs rose by 34% resulting in close to $900 million in expenses for Air Canada for the 2008 year alone. From analyzing the 2011 income statement, (Air Canada, 2012) the operating cash flow per share (-0.25) is less than earnings per share (-0.22). The comparison depicts that the earnings are low quality since the company is generating less cash than what is reported on the income statement. Although the earnings per share is low quality, the chart illustrates a very apparent rise in stock prices from September 2012 to November 2012. In the Air Canada 2012 third quarter news release, the corporation stated that this was due to their pursuit of international growth opportunities and the ongoing transformation of their cost structure. A significant change

Page 3 of 13 was the new realignment initiatives that included the transfer of fifteen regional Embraer 175 aircrafts to one of the Air Canada Express operators, Sky Regional Airlines. Also included in the realignment was the deployment of the new Bombardier Q400s by Air Canada Express operator Jazz and the introduction of two new Boeing 777 aircrafts set to hit the mainline fleet next year. (Air Canada Reports Third Quarter 2012 Results, 2012) (Refer to Graph 2, Stock Market Analysis) The current nature of risk for the stock can be considered low. The valuation is based on its performance since the 2008 fall in prices. Since then, the company has had an overall steady stock price coupled with increasing sales. Air Canada has recently made the announcement of a low cost carrier, which will penetrate the low cost flight market in Canada. The risk rests on if the company can stay focused and consistent with the goals of longevity that they have put forth. If they follow through with the alignment as well as the low cost carrier there is no doubt that the corporation will continue to play a large role in the Canadian flight market. (Refer to Graph 3, Stock market Analysis) Air Canadas dispute with the pilots union was resolved recently and the two parties came to an agreement. Air Canada also created a low cost carrier, which not only competes with the nations other low cost rivals but will also be wholly owned by the corporation. As mentioned earlier the realignment will be increasing the amount of flights adding to Air Canadas momentum. With all the actions of expansion plans and arbitration rules the outlook for the Canadian flight corporation looks very positive in terms of stock prices. The recent increase in stock reflects the upward surge and if all remains constant will continue to steadily rise in the near future.

RATIO ANALYSIS & COMPARISON TO INDUSTRY AVERAGES

The analysis of a companys ratios allows for a better assessment of the performance and standing in comparison to competitors. This analysis helps in determining the companys profitability, sustainability, efficiency at managing resources and assets, and also the stocks attractiveness on the market. In order to assess Air Canadas 2011 performance, the ratios

Page 4 of 13 obtained were compared to those of 2010 as well as to those of WestJet (Appendix W(2)), another Canadian airline company, for the same period. Air Canadas ratio analysis table (Appendix A(2)) shows that only a few ratios (i.e. receivables turnover, debt-to-total-assets, assets turnover, and price earnings ratio) increased during 2011. The other ratios mostly decreased in 2011 in comparison to 2010. The increase in receivables turnover from 13.66 in 2010 to 14.59 in 2011 shows that Air Canada can continue offering credit and improve its collection of receivables. However, while both WestJet and Air Canada have an increase in receivables turnover, Air Canada did not perform as well as their competitor. In addition to having larger credit sales than Air Canada, WestJet was also able to maintain much lower account receivables and therefore have a much higher receivables turnover ratio. As a result, despite the small increase in the receivables turnover ratio for Air Canada, the company was not able to outperform its competitor. Air Canadas debt-to-total-assets also increased from 3.42 to 4.10 while WestJets remained constant. This is an indicator of negative performance since total liabilities increased significantly from $11,441 million in 2010 to $13,639 million in 2011. It can be concluded that Air Canada is increasing their debt load and will need to borrow additional funds in order to carry on with their operations & activities. Although the price earnings ratio increased mathematically in 2011, the earnings per share ratio is negative due to the loss incurred in 2011 and therefore makes the analysis of this ratio conceptually irrelevant (Investopedia 2012). On the other hand, numerous ratios of liquidity, solvency, and profitability have decreased, and they do not reflect the industry performance when Air Canada is compared to WestJet head to head. The liquidity ratios help in determining the ability of a company to pay off its current liabilities (Investopedia 2012). The working capital of Air Canada decreased from $223 million to $174 million and their current ratio shows a slight decrease from 1.07 to 1.06. This is mainly due to a greater increase in current liabilities over current assets. Similarly, despite an increase in working capital, WestJet also showed a slight decrease in their current ratio from 1.53 to 1.51. Moreover, although their current liabilities increased, they were able to increase their current assets more. The variations do not indicate a significant fall in industry performance, and therefore no conclusive claims can be made on Air Canadas performance. The cash current debt coverage ratio definitely indicates a poor performance from Air Canada compared to WestJet. Air

Page 5 of 13 Canada's ratio decreased from 0.30 to 0.19; mainly due to an increase of $75.5 million in the average current liabilities and a decrease of $347 million in net cash provided by operating activities. On the other hand, WestJet increased their ratio from 0.53 to 0.57; this shows not only that they are able to keep the proportion of operating activities cash to current liabilities relatively stable, but they have also been able to increase the amount of cash that they have on hand compared to their current debts. These liquidity ratios show that Air Canadas negative performance does not reflect the economic environment, as WestJet is able to show growth. It can therefore be reasonable question Air Canadas ability to meet their short-term obligations. The ratios of solvency help to measure the ability of a company to pay back its total liabilities; it is an indicator of a companys survivability (Investopedia 2012). Air Canada's solvency ratios indicate hints of negative performance compared to WestJet. Indeed, by looking at the two companies 2011 free cash flow, both decreased, significantly, however, WestJet's numbers were lowered to $-3,047.62 million due the $3,500 million in dividends paid. Had they not paid any dividends (like Air Canada), their free cash flow would be $452.38 million, which is still greater than Air Canada's free cash flow of $439 million. Additionally, the decrease in Air Canadas cash provided by operating activities greatly reduced its free cash flow and did not work in favour of the company. Next, the times-interest-earned ratio of Air Canada, which shows its ability to pay interest due, decreased from 0.94 times in 2010 to 0.23 times in 2011 (Kimmel et. al 2009). This number in 2011 indicates that Air Canadas earnings before interest and tax expenses were 0.23 times the interest expense amount, that is, it did not earn enough to cover its interest coming due. Compared to WestJet, their ratio had increased from 2.88 in 2010 to 4.41 in 2011 indicating an increase in their ability to pay their dues and to generate earnings. Lastly, the cash total debt coverage ratio of the two companies denotes a clear unfavourable growth from Air Canada. Their ratio lowered from 0.09 to 0.05, compared to WestJet whose ratios increased from 0.20 in 2010 to 0.24 in 2011, illustrating that the cash they earned from operating activities covers a lesser portion of their total debts. They would then need to liquidate their other assets if all debts were to be paid back in that following year. While WestJet steadily grows, Air Canadas figures are constantly declining. The solvency ratios and the intercompany comparison show that Air Canadas poor performance is mainly due internal factors rather than external ones and renders the companys long-term survivability questionable.

Page 6 of 13 The ratios of profitability are used to assess a company's ability to make money as compared to its expenses (Investopedia, 2012). In the case of Air Canada, most of their profitability ratios point towards a declining profitability of the company. Indeed, their profit margin ratio has gone down significantly from -0.0022 (-0.22%) in 2010 to -0.02 (-2%) in 2011. Despite an increase in sales, their net loss increased significantly over ten folds from $24 million in 2010 $249 million in 2011 as opposed to WestJet who have been able to raise their ratio from 0.03 to 0.05, and their net earnings from $90.197 million to $148.702 million. The same increase in net loss also impacts the return on assets of Air Canada significantly which can be seen by a decrease from -0.0023 in 2010 to -0.03 in 2011 as opposed to WestJet's ratio which increased stably from 0.03 in 2010 to 0.04 in 2010. However, the asset turnover ratio of Air Canada increased from 1.05 to 1.17 showing that, despite a lower average total asset, the company was able to generate more sales from its assets. Return on common shareholders equity shows a mathematical increase but the company suffered a deficit during the year that reduced the average common shareholders equity amount from $79 millions to -$2,647 millions in addition to the net loss. The increase is therefore irrelevant as the situation is actually not in favour of the company. The earnings per share ratio, which indicates the net earnings, made on each common share also decreased from -0.09 to-0.90 due to the net loss incurred (Kimmel et. al 2009). This indicates a loss of $0.90 on each share issued. WestJet seems to fare better; their ratio increased from 0.62 in 2010 to 1.06 in 2011. It is then possible to see that WestJet has been more profitable than Air Canada in 2010 and 2011. The payout ratio and dividend yield stayed constant at zero for Air Canada, while WestJet went from zero in 2010 to 23.54 in 2011. WestJet has been able to pay out dividends whereas Air Canada has still not paid any dividends in the last two years; this denotes better profitability and stronger investor relations from WestJet. Additional evidence of low profitability can be seen in the decrease in the market price per share of Air Canada that decreased from $3.47 per share to $1.01 that further reflects their poor profitability. The acid test ratio, which evaluates a companys ability to meet its current liabilities using only its current assets lowered for Air Canada to 0.89 in 2011 from 0.91 in 2010 due to a decrease in their cash account (Investopedia 2012). This shows that Air Canada is not able to cover its immediate liabilities without having to sell other assets. Lastly, a comparison of the book value per share of the two companies indicates that Air Canada performed poorly (Investopedia 2012). This number indicates how much money is associated to each share when all assets are liquidated and all debts

Page 7 of 13 are paid. For 2010, Air Canada's ratio was already in the negative at -4.63; it decreased further down to -14.41. If Air Canada had to dissolve, they would not have enough funds to pay back to their shareholders. This ratio makes Air Canada pale even more in comparison to WestJet whose book value per share increased from 8.99 in 2010 to 9.91 in 2011. Through the profitability ratios intercompany comparison, it can be said that Air Canada's profitability is clearly declining unlike WestJet. Through the analysis of their liquidity, solvency, and profitability ratios, Air Canada and WestJet have been compared to assess the former's performance. It was noticeable that Air Canadas performance is most significantly declining in term of solvency and profitability. It would be advisable not to invest in Air Canada before analyzing more deeply into their operations & activities.

COMMON SIZE AND TREND ANALYSIS

Another way to analyse the companys performance is by using a common size and trend analysis. The data used for the analysis are from the Air Canada financial statements, more specifically, the consolidated statement of operations and comprehensive income, as well as the consolidated statement of financial position. The trend analysis compares the changes of the companys different accounts over time; for the purpose of this report, the base year is 2010. As for the common size analysis, the accounts from the income statement are compared to the yearly net sales and the accounts from the balance sheet are compared proportionately relative to the total assets. The trend analysis (Appendix) will allow us to make a more informed decision as to whether or not Air Canada is worth investing in because it can also be used to forecast the performance of a company.

Air Canada Income Statement Analysis

By looking at the income statements, there is a growth of 8% in 2011 for the companys revenues and expenses. In fact, Air Canada has experienced a growth in passengers traffic that resulted in higher revenues compared to the previous year. In 2011, the operating expense for aircraft fuel increased by 27% due to the increase of fuel price. It also experienced a decrease of 20% in interest expense coming from the repayment of debt. Furthermore, the operation income

Page 8 of 13 has decreased by approximately 30% and the companys non-operating expenses have increased by 42%; this major inconsistency resulted from losses on foreign exchange. In 2011, the Canadian dollar was weaker than the US dollar and most of the company expenses incurred were in US dollars. Most of these numbers show that Air Canada did not have a profitable year. In fact, in the span of one year, the net loss multiplied itself by ten times and its total comprehensive income decreased by three times the amount of 2010. Demand decreased for air transportation during tough economic conditions. Labour cost is one important expense and in 2011, many labour disruptions and work stoppages occurred along with several union disputes; causing the operation of the company to halt at various times. Recently, Canadians authorities have significantly increased airport user fees and air navigation fees due to the privatization of airports. By looking at the income statement vertical analysis, the proportions of each amount did not differ greatly between 2010 and 2011 (except for the comprehensive income accounts which decreased, as stated above). The tables demonstrate that the amount of sale revenues are fairly equal to the companys operating expenses which means that income is not very high. Overall, by taking into account the biggest variances between 2010 and 2011, investing in Air Canada might be risky if the trends do not change. Indeed, the overall income for the company in 2011 are negative due to multiples issues such as economic conditions, pension plan funds, labour issues, fuel prices, contractual covenants, foreign exchange rate, competition and low-cost domestic carriers.

Air Canada Balance Sheet Analysis

Based on the vertical and horizontal analysis tables (see Appendix), the assets in 2011 fluctuated a little bit compared to those in 2010. Property and equipment decreased by 10% due to depreciation expense. As for the 25% reduction of the current portion of long-term debt and leases, the notes explain that this was due to repayment and also explained the decrease of 5% in working capital. The overall liabilities increased by 20% - this may not be a good sign if the company is unable to make sufficient payments in the future; such as when there was a large increase in pension and other benefits liability which amounted to 67%. Moreover, the deficit in 2011 has doubled and the total equity has decreased three times the total equity in 2010. The major increase in deficit comes from a list of risk factors including uneasy economic conditions, 8

Page 9 of 13 increasing regulations and more competition. Due to its major amount of debt to repay, which includes pension and other benefit liabilities, the company may face difficulty to find loans to finance these debts. It has also used most of its cash flow from operations to pay its debts and obligations that resulted in fewer investment opportunities and ability to lower debt. Interest rates must also be taken into account as an increasing debt load entails great portions of payments to interest. Also, in 2011, the account receivables increased by 10%, this account should not be so high as collections are not always assured when facing difficult economic times. The state of the company can also be found by comparing the balance sheet accounts with the amount of total assets. An important part of Air Canada assets are property and equipment that represent half of its total assets. Overall, the proportion of each accounts are mostly stable from 2010 to 2011. However, Air Canada is not doing so well since some of their liabilities such as long-term debt and pension liabilities equal to 41% and 58% of total assets respectively; these are not good signs for the company. It is important that the company is able to fulfill its obligations especially if the amount of debt is high or else the company may be faced with bankruptcy in the near future. Moreover, the companys total equity is 42% lower than the total assets; having a poor equity also results in a competitive disadvantage for Air Canada. Investors can see that 2011 was not a good year for Air Canada. Investing in Air Canada would be risky due to its major deficit and net loss. Indeed, the company is now vulnerable due to the economic downturn and its actions when facing competition. Air transportation is a strongly competitive industry and throughout the years, more and more carriers have entered the market, which has decreased the overall performance of Air Canada. For example, low-cost carriers are known to drive down the overall fare prices. Similarly, airline fares and passenger demand faces high fluctuations that make the performance very difficult to foresee. Air Canada should change its strategies in order to gain profitability and have a better position in the future, as its current operations are not able to cover all the expenses incurred.

ANALYSIS OF FINANCIAL STATEMENTS

It is important to analyze the presentation of the financial statements as a whole and its parts, as this will make it easier to interpret and better understand the significance of certain values. Specific parts of the financial statements that will be discussed include certain methods of valuation and disclosure used as well as certain accounting policies and estimates.

Page 10 of 13 Air Canada operates under IFRS as of January 1, 2011, as adopted by Canadian GAAP for public corporations on that date. Air Canada included restated statements ending December 31, 2010 using IFRS so as to make these reports more comparable to future years. Due to the change in standards, certain trends and information from statements prior to IFRS may not be able to be extrapolated, or may need to be reanalyzed in order to be properly analyzed. Air Canadas financial statements include a significant amount of information within its notes as opposed to putting it on the face of the financial statements. The faces of the statements are abbreviated, with more specific disclosures in the notes. While one can get a decent overview just by looking at the face of the statements, notes will often be of relevance to get more detail and a better overview of the entitys financial state. This is especially true for Air Canadas balance sheet accounts. Often if a net value is shown on the face, the notes have supporting schedules showing how Air Canada came to these net values. The balance sheet is classified by current and non-current assets/liabilities, with current coming first and accounts ordered by liquidity within their category. Air Canada presents a statement of operations separately and includes any net gain/loss from this statement into the statement of comprehensive income. This emphasizes the highly relevant net gain/loss from operations. Air Canada does not have any discontinued operations and therefore no assets held for sale. However, when there are assets held for sale, they are recognized at the lower of carrying value and fair value less costs to sell (Air Canada Financial Statements, 2011, page 90). Cash and cash equivalents include investments with original maturities of three months or less at year-end (December 31). At year-end 2011, these investments were $356 million and more specifically, include bankers acceptances and discount notes having original maturity of three months or less. Separately disclosed on the balance sheet just below cash and cash equivalents are short-term investments, which are bankers acceptances and discount notes with original maturity of over three months but not more than one year, as at year-end. Restricted cash includes funds held in trust by Air Canada Vacations due to regulated regarding advance ticket sales (Notes 3P, 3Q and 3R in financial statements) (Air Canada Financial Statements, 2011, page 90). Accounts receivable are measured at amortized cost using the effective interest rate method (Air Canada Financial Statements, 2011, page 86). Air Canada presents its expenses mostly by nature while those presented by function are categories of expenses, with the nature of the individual expenses being disclosed in the notes.

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Page 11 of 13 While the presentation of those expenses by function can often provide more relevant information to users, the allocation of expenses to function should be analyzed to gain more relevant information regarding expenses. In addition, some of the expenses are grouped together as one expense line. The notable example is the expense line for Depreciation, amortization and impairment (Air Canada Financial Statements, 2011, page 78). It will likely be relevant to refer to the notes to understand the breakdown of depreciations, amortizations and impairment resulting in this net value. These depreciations, amortizations and impairments costs are included in the notes of the assets from which they resulted, which make it difficult to gather the specifics regarding the value of each expense. In general, this method should be changed so as to provide more clear disclosure of these expenses. In addition, accumulated depreciation of assets should be shown on the face of the statement (only the carrying value is shown on the face), not just in the notes of the asset to which it is related. As a general note, the majority of this expense line is from depreciation of property and equipment as seen in Note 5 (Property and Equipment). The statement of cash flows is reported using the indirect method. Specific details regarding where money is coming from and going to is not disclosed directly. The cash flow statement may therefore require further analysis to examine the breakdown of cash inflows and outflows from operating activities, which will lead to a better understanding of the entitys cash situation. This analysis will make it easier to form and examine operating cash flow trends and facilitate the evaluation of the companys ability to generate net cash from operating activities. Air Canada makes several estimates in reporting its financial statements. One especially critical estimate is depreciation/amortization; more significantly depreciation. Air Canada depreciates each asset separately and, to remain accurate, Air Canada reviews its estimates at least annually and accounts for any adjustments prospectively through depreciation/amortization. Property and equipment, which make up most of the depreciation expense, are depreciated to the estimated residual value based on the straight-line method (Air Canada Financial Statements, 2011, page 88). This seems appropriate, as the property and equipment of Air Canada are longlived and high-end equipment, and wouldnt depreciate much faster in its early years (as in the declining method). Generally, an asset depreciated using declining method will have a greater depreciation expense in its early years and a smaller one in its late years, relative to straight-line depreciation of the asset. Therefore, if most of the value of Air Canadas depreciable assets come from assets in their early years, declining balance would often lead to a lower net income now;

Page 12 of 13 and if in their later years, a higher net income (relative to if the straight-line method were used). Carrying value of the asset on the books will always be less when using the declining method. In either case, accumulated depreciation at asset retirement will be the same, the distinction is whether it accumulates more in the earlier years and less later (declining) or an equal amount annually (straight-line). Residual values of aircrafts with remaining useful lives greater than five years have been reduced by 50% (due to sensitivity analysis) resulting in an increase of annual depreciation expense in 2001 of $17 million (Air Canada Financial Statements, 2011, page 93). A reduction in estimated residual value under the straight-line method increases depreciation expense and accumulated depreciation of the asset and vice-versa. Air Canada values property and equipment at fair value and intangible assets are initially recorded at cost with indefinite life intangibles not being amortized while those with finite lives are amortized on a straight-line basis. Property and equipment with a carrying value of $318 million is collateral for long-term debt and financing leases (Air Canada Financial Statements, 2011, page 100). Air Canadas policy is to capitalize interest if it is related to the acquisition, construction, or production of an asset that takes a long period of time before its intended use, otherwise it is expensed. Expensing more now, rather than capitalizing, would mean lower net income now, but higher net income later (relative to if and it were to be capitalized) since the interest costs capitalized would be expensed in future years through depreciation. If a choice were available, the better option would depend on the pros and cons of expensing now versus deferring expenses through future depreciation. Aircraft fuel and spare parts and supplies inventory are, as required by IFRS, measured at the lower of cost and net realizable value. The cost is established using the weighted average formula (Air Canada Financial Statements, 2011, page 88). If the cost of purchasing inventory does not change much over time, the effect of the inventory cost method choice will not be significant. However as the value of the inventory changes, the choice becomes quite relevant. Weighted-average best reflects flow of costs and inventory value on the balance sheet. This is since it includes the current costs of inventory as a part of the inventory expense and the subsequent decrease in inventory value, as opposed to FIFO where inventory cost is original cost of the asset first purchased (irrespective of changing costs). Therefore when there is a change in purchase costs, none of this change of cost would show in inventory expense under FIFO, which is why FIFO less accurately represents the flow of costs. If FIFO was used and inventory costs

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Page 13 of 13 rose, inventory expense would be less (causing net income to be greater) and inventory on balance sheet would be greater. Consequently, if purchasing costs have declined, inventory expense would be greater (causing net income to be smaller) and inventory on the balance sheet would be less.

CONCLUSION
Unfortunately, Air Canada is not a worthwhile investment. Although the airline industry has shown some growth since the recession in comparison to other industries, it just simply is not in a good position. The stock has been rising, however, its profitability is shadowed by the forthcoming of cheaper alternatives such as WestJet as well as a continually declining profit margin. Similarly, our analysis of their ratios only depicts a bleak future in regards to Air Canada meeting their financial obligations to creditors.