Dell`s Working Capital

Executive summary

This case study analysis of Dell’s Working Capital and its financial statements has been done to come up with a plan for the company to finance its future growth.

Dell Computer Corporation has proven to be one of those companies that revolutionize an entire industry. They were the ones to introduce the Build-To-Order business model in the computer manufacturing sector, which gave them a tactical as well as a competitive advantage over other companies. This new business model along with its working capital management and allocation of resources provided Dell with the opportunity for substantial growth in the 1990’s. We forecasted, using the percent of sales method, for the financial statements of 1996 and 1997.

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The sales increased by 52% in 1996 and 50% in 1997. The financial ratios of our pro forma balance sheets were calculated, and the information was used to figure out the external funds needed by Dell to finance its growth. As per the analysis, there was no requirement for any external funds because the EFN (External Funds Needed) came out to be negative. According to our analysis Dell’s operational and financial structure seems to be organized in such a way that it does not need any external funding for substantial growth opportunities.

Due to factors like its Build-To-Order model, working capital management, and inventory system, Dell has enough resources to finance its growth internally and without any need for external financing. Also, the company has the potential to payout its long-term debt and increase its dividend policy by using its internal funds. All this can be done without harming the prospect of future growth and expansion potential.

Introduction

Dell Computer Corporation was founded by Michael Saul Dell in 1984. Dell designs manufacture sells, and services personal computers.

The company’s growth rate increased considerably once it started marketing and selling its own brand personal computers by taking orders over the phone (and later online), and shipping directly to customers. This was Dell’s core strategy. This, along with the Build-To-Order model (similar to Toyota’s Just-In-Time, a.k. a. JIT, system) gave Dell the upper hand over its competitors. Dell has much smaller investments in working capital than its competitors because of this Build-To-Order model. It also helps Dell to take advantage of the benefits of reductions in component prices and to introduce new products in the market more frequently.

Over the years, since its inception, Dell has grown quickly and has been able to finance its growth internally through its efficient use of working capital and its profitability. During the mid-1990s, the PC industry was growing at a rapid pace with Dell leading the revolution. As mentioned earlier, Dell introduced its Build-To-Order model to the industry, which allowed customers to have customized computer systems with the latest technology. Dell was able to keep its Work-In-Process (WIP) and finished goods inventory at very low levels.

These models proved very good for keeping costs low, but Dell also wanted to capitalize on the prospect of future growth. The most important questions facing Dell were – how to grow and at what cost. The purpose of this research is to analyze Dell’s core strategy, and its working capital management, and come up with a plan to finance its future growth by evaluating its financial statements.

Research and analysis

Dell revolutionized the PC industry in the 1990s because of its strategic innovation of the Build-To-Order model. It was a bold new business model that changed the rules of the industry.

Through our research, we have come to know that in today’s competitive world, a brilliant business model alone does not create a sustainable advantage, unless it is supplemented by operational excellence, continuous identification, and the adoption of best practices. Dell’s Competitive Advantage Dell set itself apart from the competition by developing a system to better manage its working capital. While competitors focused on forecasting future sales, Dell developed the Build-To-Order model. This allowed Dell to maintain their inventory cost at a minimum, which in turn lowered its cost of goods sold.

Through this process, Dell’s Work-In-Process (WIP) inventory and finished goods inventory in relation to the present total inventory in the 1990s was approximately 10% to 20%. This knocks out the competition which stood at about 60%. Dell definitely set itself apart from the competition. Dell made sure to master this process which allowed them to provide a service to the market that the competition could not deliver as quickly as Dell. They were able to customize orders according to the customer’s needs and do it quickly.

As noted in Exhibit 2, in the fourth quarter of 1994 Dell’s Daily Sales of Inventory (DSI) was 33 while the closest competitor IBM was at 57. This means that Dell was selling its inventory nearly twice as quickly as the closest competitor. This type of advantage is what propelled Dell as a top competitor within this market. In January 1996, for example, Dell had inventory to cover 32 days of sales while Compaq Computer had inventory to cover 73 days of sales. One way for us to quantify Dell’s competitive advantage is to calculate the increase in inventory Dell would have needed if it operated at Compaq’s DSI level.

Using Dell’s Cost of Sales (COS) for 1995 contained in Exhibit 5 and the information on DSI contained in Exhibit 2: Additional inventory at Compaq’s DSI = (Dell’s COS) (Compaq’s DSI – Dell’s DSI)/360 days = [($2,737) (73-32)]/360 = $312 million. This $312 million, in perspective, represents 59% of Dell’s cash and short-term investments, 48% of stockholder equity and 209% of its 1995 income, as shown in Exhibit 4 and 5. The build-to-order setup also enabled Dell to easily make changes to their systems as new updates were available. This was extremely evident in 1994 when Intel Corporation found that its chip was flawed.

Unlike Dell, the competition had so much inventory that it had to continue to sell the flawed systems. Dell was able to start selling their new systems with the unflawed chips. Another strong example took place in 1995 when Dell had the competitive advantage of being able to add the Pentium technology to their entire line, while the competition were not able to adopt the technology as quickly because of their large inventory. As shown in Exhibit 3, 75% of Dell’s sale in 1996 was from computer systems that had Pentium processors. Dell’s Build-To-Order model and resulting inventory had some risks.

Component shortages were a disadvantage of Dell’s aggressive inventory model and, on occasion, Dell had to order backlogs because of parts shortages. While revenue may have been lost due to canceled orders or delayed until supplies were available, the rapid technological change made the advantages of Dell’s approach outweigh its disadvantages. Funding 52% Growth in 1996 Dell’s sales jumped up by 52% in 1996 as shown in Exhibit 1. Dell was able to fund this expansion in 1996 by addressing the financial requirements from several angles.

First, we must understand exactly how much working capital Dell needed to come up with in order to fund the growth. We calculate this by finding Operating Assets (Total Assets – Short Term Investment). Operating Assets for 1995 were in the amount of $1,110 million (Exhibit 6). This as a percentage of total sales is 32%. Now we know how much money was needed to fund $3,475 million dollars in sales. The percentage of sales method can be applied to any increase in sales to find the additional cost of Operating Assets needed in relation to sales.

From 1995 to 1996 Dell’s sales increased by $1,821 million ($5,296 million - $3,475 million). Using the percentage of sales method for operating assets to sales we discover that Dell needed an additional $583 million (32% of $1,821 million) to fund the 52% growth in sales. Exhibit 7 shows that the projected 1996 balance sheet using the percentage of sales method. Two sets of projections are made. In both, Operating Assets (Total Assets less Short-Term Investments) are assumed to grow with sales based on 1995 account balances as a percent of 1995 sales. Short-Term Investments are assumed to be constant.

The projected 1996 assets equal about $2. 2 billion, an increase of about $583 million. If a 1995 profit margin of 4. 3% is held, Dell would have realized $227 million in net income, leaving a funding requirement of $355 million ($583 million less $227 million). Assuming that liabilities remain constant as detailed in the Fixed Liabilities projection in Exhibit 7. The Proportional Liabilities projection assumes that the liabilities grow as sales grow based on the 1995 sales ratios. Those projections show that Dell would have excess funding of $136 million.

Thus, as of 1995, Dell would be projected to be able to grow at 32% without increasing its leverage. In all actuality, Dell was able to cut the proportion of operating assets to sales from 1995 to 1996. Assets went from $1,594 million to $2,148 million, however, Operating Assets (Total assets – Short Term Investment) went from $1,110 million in 1995 to $1,557 million in 1996. In relation to total sales Operating Assets went from 32% in 1995 to 29. 4% in 1996. This decrease of 2. 6% shows that while sales increased, Dell was able to decrease inventory, internal process costs, and accounts receivables per dollar of sales.

Operating efficiency increased, reducing the funding costs of growth. To determine the actual effect operating efficiency had on costs we multiply the 2. 6% decrease by the sales of that year ($5,296 million * 2. 6%) giving Dell $138 million in cost savings. This reduces our estimate of total funding costs from $583 million to $445 million. Gross Margin for Dell also increased significantly during 1996, partially giving Dell a higher Net Profit. In addition to cost cuts on operating assets, Dell managed to decrease (as a percent of sales) Cost of Sales and Operating Expenses.

These cuts lead to an increase in profit margins from 4. 3% in 1995 to 5. 1% in 1996, giving Dell money to finance the growth. The actual Net profit was $272 million in 1996 as shown in Exhibit 5. On the liability side of the balance sheet, Dell increased its current liabilities by $187 million. That increase was $204 million less than the increase that would have occurred with a proportionate increase in current liabilities. As a percent of sales, current liabilities fell from 21. 6% in 1995 to 17. 7%; Accounts payable was 8. % of sales, a decrease of nearly 3% (Exhibits 5 and 6). While long-term debt remained the same, the percentage to sales of current liabilities decreased, giving Dell additional working capital to fund the growth. Upon totaling the cost savings, net profit, and liabilities the sum equals $597 million ($138 million + $272 million + $187 million). This amount far surpasses the estimate of $582 million needed to fund the growth. In summary, Dell internally funded a 52% growth in sales in 1996, largely by increasing its asset efficiency and profitability. Funding 50% Growth in 1997

In order to evaluate Dell’s funding options for a 50% sales growth in 1997, we will first calculate the Operating Assets and Net Profit as a percentage of sales for 1996. Operating Assets as a percentage of sales for 1996 = Total Assets – Short-term Investments = $2,148 million - $591 million = $1,557 million. Net Profit percentage = Net Profit / Sales = $272 million / $5,296 million = 5. 1%. In order to achieve 50% sales growth, the percentage increase needed for Operating Assets would also be the same which is based on the assumption that when sales increase by 50% then Operating Assets would increase by the same proportion.

Hence for 1997, Dell would require $1,557 million * 1. 5 = $2,336 million worth of Operating Assets. This implies an increment of $779 million ($2,336 million - $1,557 million) in Operating Assets. Next, we would forecast the projected 1997 balance sheet using the percentage of sales method. We have prepared the pro forma balance sheet for 1997 keeping in mind three different financial perspectives or assumptions. For all three assumptions, assets are based on 1996 sales ratios except for short-term investments that are held at 1996 levels. In 1996, assets other than short-term investments were about 30% of sales.

As mentioned earlier, in order to achieve the additional sales of $2,648 million (50% of $5,296 million) additional Operating Assets of $779 million would be required. The projected balance sheet of Dell for 1997 is presented in Exhibit 8. The first liability assumption in Exhibit 8 is that liabilities remain fixed at 1996 levels. If the 1996 profit margin of 5. 1% remains constant, then the net profits of $407 million would fund part of the additional assets. The pro forma balance sheet would still not match and hence Dell would require additional funding of $373 million. The second ability assumption in Exhibit 8 is that liabilities increase with the 1996 sales ratios. With this assumption, the liabilities and net profit as a percentage of sales will also increase proportionally by 50% for 1997. Exhibit 9 shows the projected Profit and Loss statement of Dell for 1997. Total projected liabilities for 1997 would be Liabilities (1996) * 1. 5 = $1,175 million * 1. 5 = $1,763 million. This way Dell would have excess capital of $215 million. From the two assumptions made above, the second one is more plausible because the chances of liabilities remaining fixed over the year are very low.

From Exhibits 8 and 9 we can see that Short-Term Investments will be around $591 million for 1997. This way we would have a total of $407 million (Net Profit) + $588 million (Increase in Liabilities) + $591 million (Short-Term Investments) = $1,584 million available, which would be above the required increase in Operating Assets of $779 million. So we can see that Dell would be able to fund it's 50% projected growth for 1997 internally. Dell may choose to allocate these funds to different sectors and still perform at maximum capacity.

The third liability assumption made in Exhibit 8 is of repurchasing $500 million of common stock and the repayment of its long-term debt. The other liabilities are assumed to increase as per the percentage of sales method. As a result of reducing debt and equity capital, Dell would create a huge cash shortfall of almost $900 million ($861 million to be precise). One way to overcome this shortfall would be to sell its Short-Term Investments. But, as we can see from Exhibit 6, Dell’s Short-Term Investments have grown at a substantial rate from 1994 to 1996.

Therefore, this decision might be against the company’s policy to withdraw funds from a highly prospering sector. A more likely and effective method for Dell to eliminate the projected shortfall would be by increasing its asset efficiency or improving profitability. To determine the magnitude of the improvements in asset efficiency required, it is necessary to determine the projected average daily sales in 1997 - $22. 1 million per day (150% * 1996 sales of $5296/360 days) and the projected average daily cost of sales - $17. 6 million (150% * 1996 COS of 4229/360 days).

The $861 million shortfall, therefore, corresponds to 39 days of sales and about 49 days of COS. Exhibit 2 shows that Dell’s cash conversion cycle was at 40 days in the fourth quarter of 1996. Thus, to find the shortfall resulting from debt repayment and equity repurchase, the cash conversion cycle would have to become negative. This can be done by increasing payables by 10 days, to their historic level of 43 days. That still leaves a substantial capital shortfall that would require substantial improvements in both inventory and receivables, and perhaps by extending payables beyond the historical levels.

Dell can also eliminate the 1997 projected capital shortfall resulting from debt repayment and repurchase through improvements in profitability. A 1% increase in profit margin increases net income by about $53 million. Although it is unlikely that Dell could fully fund the repayment and equity repurchase through margin improvements alone, the margin improvements reduce the required working capital improvements. A combination of both profit improvements and working capital improvements seems to be the only reasonable alternative to funding the shortfall, with the bulk of the gains coming from working capital improvements.

Besides, there are benefits associated with the repayment of long-term debt and the repurchase of equity. Improvements in working capital would enhance Dell’s business strategy and help improve its profitability by reducing obsolescence and lowering component costs. The benefit from debt repayment will be more financial flexibility and the absence of debt covenants. For the equity repurchase, the rationale seems to be that insiders (who would not participate in the repurchase) believed Dell’s stock was underpriced in the stock market. The repurchase would, therefore, be a value-increasing decision for the remaining shareholders.

Conclusion

Exhibits 10 and 11 contain Dell’s Profit and Loss Statement and Balance Sheet for 1997. Dell’s sales grew over 47% over the prior fiscal year. Based on 1996 asset-to-sales ratios adjusted for short-term investments, Dell would have needed an additional $724 million in operating assets to support the increase in sales. We can see that Dell was able to fund its 1997 growth internally, repay its long-term debt, and repurchase $500 million in equity through a combination of working capital and margin improvements. Improvements in working capital provided almost $900 million in funding.

Dell generated its 1997 revenue with only 7% more working capital than in 1996. Margins increased by 1. 5% of sales during 1997, providing about $120 million in funding. For 1997, Dell’s return on sales rose to 6. 6%, up from 5. 1% a year earlier. Though average revenue per unit fell by 6%, gross margin increased because of reductions in component prices and a sales mix shift to higher margin products such as servers and notebooks. For 1997, the gross margin was 21. 5% versus 20. 2% in 1996. Operating margin also improved as an operating expense as a percent of sales fell 12. 3% from 13. 1% a year earlier.

Net profits totaled $531 million, of which $120 million was the result of improved margins over 1996. This additional income provided internal financing for Dell’s growth.

Exhibits:

1. Exhibit 1 Dell’s annual worldwide sales dollar growth versus industry Calendar YearDella Industry 199163%-2% 1992126%7% 199343%15% 199421%37% 199552%31% Dell’s fiscal year closest in alignment to calendar year stated
2. Exhibit 2 DSI comparison of Dell, IBM, and Compaq QuarterDellIBMCompaq Q41994335768 Q41995325473
3. Exhibit 3 Working Capital Financial Ratios for Dell DSI aDSO DPO cCCC d Q19340544648 Q29344515540 Q39347525148 Q49355545356 Q19455585657 Q29441534351 Q39433534541 Q49433504241 Q19532534540 Q29535494440 Q39535504639 Q49532474435 Q19634474239 Q29636504343 Q39637494343 Q49631423340 a DSI (Days Sales of Inventory) = Net Inventory / (Quarterly COGS/90) b DSO (Days Sales Outstanding) = Net Accounts Receivables / (Quarterly Sales/90) c DPO (Days Payables Outstanding) = Accounts Payables / (Quarterly COGS/90) d CCC (Cash Conversion Cycle) = DSI + DSO – DPO
4. Exhibit 4 Percent of Dell Computer Systems Sales by Microprocessor Computer SystemsFY94FY95 FY96 386 models7%0%0% 486 models92%71%25% Pentium models1%29%75%
5. Exhibit 5 Profit & Loss Statements for Dell Computer Corporation (millions of dollars) Fiscal Year19961995199419931992 Sales$5,296 $3,475 $2,873 $2,014 $890 Cost of Sales4,229 2,737 2,440 1,565 608 Gross Margin1,067 738 433 449 282 Operating Expenses690 489 472 310 215 Operating Income377 249 (39)139 67 Financing & Other Income6 (36)0 4 7 Income Taxes111 64 (3)41 23 Net Profit272 149 (36)102 51
6. Exhibit 6 Balance Sheets for Dell Computer Corporation (millions of dollars) Year Ended January 28, January 29, January 30, 199619951994 Current Assets: Cash55 43 3 Short Term Investments591 484 334 Accounts Receivables, net726 538 411 Inventories429 293 220 Other156 112 80 Total Current Assets1,957 1,470 1,048 Property, Plant & Equipment, net179 117 87 Other12 7 5 Total Assets2,148 1,594 1,140 Current Liabilities: Accounts Payable466 403 NA Accrued and Other Liabilities 473 349 NA Total Current Liabilities939 752 538 Long Term Debt113 113 100 Other Liabilities123 77 31 Total Liabilities1,175 942 669 Stockholders’ Equity: Preferred Stock (Note a)6 120 NA Common Stock (Note a)430 242 NA Retained Earnings570 311 NA Other(33)(21)NA Total Stockholders’ Equity973 652 471 2,148 1,594 1,140 1,190,000 shares of preferred stock converted to common stock in the fiscal year 1996.
7. Exhibit 7 Balance Sheets for Dell Computer Corporation - Actual 1995 and Projected 1996 Year Ended January 29, January 28, 19951996 (Projected) Current Assets: Cash43 66 Short Term Investments484 484 Accounts Receivables, net538 818 Inventories293 446 Other112 170 Total Current Assets1,470 1,984 Property, Plant & Equipment, net117 178 Other7 11 Total Assets1,594 2,173 Current Liabilities: Accounts Payable403 613 Accrued and Other Liabilities 349 349 Total Current Liabilities752 962 Long Term Debt113 172 Other Liabilities77 117
8. Total Liabilities942 1,251 Stockholders’ Equity: Preferred Stock (Note a)120 183 Common Stock (Note a)242 369 Retained Earnings311 538 Other(21)(32) Total Stockholders’ Equity652 1,058 1,594 2,309 Additional funding of $136 million available 1,190,000 shares of preferred stock converted to common stock in the fiscal year 1996.
9. Exhibit 8 Balance Sheets for Dell Computer Corporation - Actual 1996 and Projected 1997 Percent of Sales Pro Forma Statements based on 50% sales growth (millions of dollars) Projected Balance Sheet Year EndedLiab. FixedLiab. IncreaseRepurchase 28-Jan-9631-Jan-9731-Jan-9731-Jan-97 Current Assets: Cash 55 83 8383 Short Term Investments 591 591 591591 Accounts Receivables, net 726 1,089 10891089 Inventories 429 644 644644 Other 156 234 234234 Total Current Assets 1,957 2,641 26412641 Property, Plant & Equipment, net 179 269 269269 Other 12 18 1818 Total Assets 2,148 2,928 29282928 Current Liabilities: Accounts Payable 466 466 699699 Accrued and Other Liabilities 473 473 710710 Total Current Liabilities 939 939 1,4091409 Long Term Debt 113 113 1700 Other Liabilities 123 123 185185 Total Liabilities 1,175 1,175 1,7641594 Stockholders' Equity: Preferred Stock 6 6 66 Common Stock 430 430 430(70) Retained Earnings 570 977 977570 Other (33) (33)(33)(33) Total Stockholders' Equity 973 1,380 1,380473 2,148 2,555 3,1442067
10. Exhibit 9 Projected Profit & Loss Statement of Dell for 1997 (millions of dollars) Fiscal Year19961997 Sales 5,296 7,944 Cost of Sales 4,229 6,344 Gross Margin 1,067 1,600 Operating Expenses 690 1,035 Operating Income 377 565 Financing & Other Income 6 9 Income Taxes 111 167 Net Profit 272 407
11. Exhibit 10 Balance Sheets for Dell Computer Corporation - 1997 Year Ended January 31, 1997, Current Assets: Cash115 Short Term Investments1,237 Accounts Receivables, net903 Inventories251 Other241 Total Current Assets2,747 Property, Plant & Equipment, net235 Other11 Total Assets2,993 Current Liabilities: Accounts Payable1,040 Accrued and Other Liabilities 618 Total Current Liabilities1,658 Long Term Debt18 Other Liabilities511 Total Liabilities2,187 Stockholders’ Equity: Preferred Stock - Common Stock195 Retained Earnings647 Other(36) Total Stockholders’ Equity806 2,993
12. Exhibit 11 Profit & Loss Statements for Dell Computer Corporation (millions of dollars) Fiscal Year1997 Sales$7,759 Cost of Sales6,093 Gross Margin1,666 Operating Expenses952 Operating Income714 Financing & Other Income27 Income Taxes210 Net Profit531

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