Dell’s Working Capital
Dell manufactures, sells, and services personal computers. The company markets directly to its customers and builds computers after receiving a customer order. This build-to-order model enables Dell to have much smaller investments in working capital than its competitors. It also enables Dell to enjoy more fully the benefits of reductions in component prices and to introduce new products more rapidly. Dell has grown quickly and has been able to finance that growth internally by its efficient use of working capital and its profitability.
Dell’s Competitive Advantage:
The extent of Dell’s working capital advantage over its competitors can be assessed using data contained in Table A of the case on days sales of inventory (DSI) for Dell and its competitors. In 1994 and 1995, Dell’s DSI was about half the level of its competitors. 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 students 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 4 and the information on DSI contained in Table A:
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 1996 income.
Aside from the conservation of capital, Dell’s low inventory has other substantial advantages. Because the industry’s short product life cycles can cause component prices to drop by 30% a year as new technology is introduced, Dell’s low component inventory reduces obsolescence risk and lowers inventory cost. These advantages may be partially quantified using the DSI data in Table A: Dell’s inventory was about 8.9% of its COS while Compaq’s inventory was about 20.3% of its COS. If technological change reduced the value of inventory by 30%, Dell would incur an inventory loss of about 2.7% of COS and Compaq would incur a loss of 6.1 of COS. The lower inventory losses for Dell imply higher profits. At Dell’s 1996 COS of $2.7 billion, the effect of the component price reductions contributes about $93 million to profits ( $2.7 billion x 6.1% - 2.7%).
Dell’s low inventory levels resulted in fewer obsolete components in inventory when technology changed, Others with high levels of inventory, such as Compaq, had to market both new and older systems. Older systems were discounted, taking away sales from newer, higher margin systems. Cannibalization was not a significant issue for Dell because of its low inventory and build-to-order models. Dell was able to grow sales by offering faster systems at prices of competitor’s slower machines.
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 order backlogs because of parts shortages. While revenue may have been lost due to cancelled orders or delayed until supplies were available, the rapid technological change made the advantages of Dell’s approach outweigh its disadvantages.
Funding 1996 growth: In 1995 total assets were 46% of sales. Short-term investments were 14% of sales. Based on its 1995 asset efficiency rates, and assuming the short-term investments were not required to support Dell’s operations, Dell would have required 32% of increased sales in additional operating assets. In 1996, sales grew to $5,296M - an increase of $1,821M or 52% - so that Dell required 32% of the increase in sales, $5892M, in additional assets to generate the incremental $1.8B in sales.
Exhibit TN-1 shows that the projected 1996 balance sheet. 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 percent of 1995 sales. Short-term investments are assumed to be constant. The projected 1996 assets equal about $2.2B, an increase of about $582 million. If 1995 profit margins of 4.3% had held, Dell would have realized $227 million in net income, leaving a funding requirement of $355 million ($582 million minus $227 million) assuming that liabilities remain constant as detailed in the Fixed Liabilities projection in Exhibit TN-1. 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 $139 million. Thus, as of 1995, Dell would be projected to be able to grow at 32% without increasing its leverage.
Exhibit TN-2 presents Dell’s sustainable growth rate. In 1995, Dell’s sustainable growth rate was 31.6%, which was below the 52% of actual growth in 1996. Typically, when a firm grows beyond its sustainable growth rate, it either increases leverage or obtains additional equity. Dell was able to grow beyond its sustainable growth rate without increasing leverage or obtaining additional equity because short-term investments were assumed not to grow with sales in Exhibit TN-1. To gauge the impact of these short term investments on sustainable growth, the Panel B of Exhibit TN-2 presents the sustainable growth rate adjusted for the short-term investments by subtracting them from the prior-year assets and equity. Net income should also be adjusted for any after-tax income associated with the short-term investments but the information is unavailable to make that adjustment. The adjusted sustainable growth rate for 1995 in Exhibit TN-2 is about 109%, which is well above its growth rate. Thus, Dell could finance substantial growth without increasing leverage of obtaining more equity.
Exhibit TN-3 highlights how Dell funded it 1996 growth by comparing the actual balance sheet with the projections in Exhibit TN-1. On the asset side of the balance sheet, Dell was able to reduce cash, receivables, inventory and other current assets relative to the projections. DSO (days sales outstanding) improved by 5 days over the prior year as accounts receivable balance as a percent of sales dropped from 13.7% from 15.2%. Inventory levels as a percent of sales also decreased slightly as DSI (days sales in inventory) improved by 1 day to 31 days from 1995 end. Overall, assets other than short-term investments fell from 32% of sales in 1995 to 29% of sales in 1996. As a result of the improved asset efficiency, Dell increased its short-term investments by $107 million and decreased current assets by $30 million.
On the liability side of the balance sheet, Dell increased its current liabilities by $187 million. That increase was $207 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 8.8% of sales, a decrease of nearly 3%. In fact, during Q4 1996, Dell paid its suppliers 11 days faster than a year earlier.
Despite a 1% erosion to gross margin, Dell’s profit margin improved from 4.3% to 5.1% in 1996. Dell’s leadership in bringing new products to market, in this case Pentium technology, helped to grow unit sales by 48% in 1996 and raise average unit revenue by 3%. The gross margin decline was attributed to aggressive pricing strategies and an account mix shift from major accounts such as corporations and government agencies to lower margin customers such as small-to-medium businesses and consumers. Lower inventory obsolescence costs as a percentage of sales helped to mitigate some of the gross margin erosion. Primarily on the strength of reduced operating expenses, notable SG&A, Dell’s higher return on sales increased retained earnings by $45 million beyond the Exhibit TN-1 projections. In addition, stockholders’ equity was increased by $49M – excluding net income (the change in retained earnings). The primary source of funding was from the issuance of common stock to employees. In total, the increase in stockholder’s equity exceeded the projections by $94 million.
In summary, Dell internally funded a 52% growth in sales, largely by increasing its asset efficiency and profitability.
Funding 50% Growth in 1997:
To gauge the required funds to grow at 50% in 1997, students should forecast the 1997 balance sheet. Exhibit TN-4 presents the forecasted balance sheet for 1997 under three assumptions about the liabilities. 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. The assumed additional sales of $2,648 million imply additional operating assets of $779 million.
The first liability assumption in Exhibit TN-4 is that liabilities remain fixed at 1996 levels. If the 1996 profit margin of 5.1% remains constant, profits will fund $405 million of the additional assets. Dell would require additional funding of $315 million.
The second liability assumption in Exhibit TN-4 is that liabilities remain at 1996 sales ratios. With this assumption, Dell has excess capital of $217 million. This is consistent with the adjusted sustainable growth calculations in Exhibit TN-2.
The third liability assumption in Exhibit TN-4 is the repayment of debt and the repurchase of $500 million of equity. The other liabilities are assumed to remain at 1996 sales ratios. As a result of reducing debt and equity capital, Dell would create a substantial cash shortfall of almost $1 billion.
If asked to choose between the three liability assumptions, students generally choose the proportional liability plan. The argument relative to the fixed liability assumption is that the current liabilities will increase spontaneously as sales grow, making it a simple and easy source of financing. Repaying the debt and repurchasing $500 million of equity creates a cash shortfall and most students will conclude it is inappropriate to add stress to the rapidly growing organization. Some students might argue that, following its performance in 1996, Dell could eliminate the projected shortfall by increasing 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 slaes in 1997 - $22.1 million per day ( 150% x 1996 sales of $5236/360 days) and the projected average daily cost of sales - $17.6 million. The $882 million shortfall, therefore, corresponds to 44 days of sales and about 65 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. Students generally doubt that it is possible for Dell to realize such an increase in working capital efficiency. Students should describe how Dell could increase its working capital efficiency. The most obvious is to increase payables by 10 days, to its 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. Exhibit TN-5 contains an example of projected improvements that would eliminate the 1997 projected capital shortfall resulting from the debt repayment and equity repurchase through improvements in working capital.
Dell can also eliminate the 1997 projected capital shortfall resulting from the debt repayment and repurchase through improvements in profitability. A 1% increase in 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.
Students should also explore the benefits or repaying the debt and the equity repurchase. It is worth emphasizing that improvements in working capital would enhance Dell’s business strategy and help improve it profitability by reducing obsolescence and lowering component costs. The benefit from the debt repayment appears to 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 under-priced in the stock market. The repurchase would, therefore, be a value-increasing decision for the remaining shareholders.
Dell’s Actual 1997 Funding
Exhibits TN-6 and TN-7 contain Dell’s Profit and Loss Statement and Balance Sheet for fiscal 1997. For 1997, Dell Computer’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.
Exhibit TN-8 shows that Dell was able to fund its 1997 growth internally, repay its long term debt, and repurchase about $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 . Dell also obtained $279 million from put options. As a result, Dell funded its growth, the debt repayment, and the equity repurchase internally, and was able to increase its short-term investments by almost $650 million.
Inventory fell dramatically during the year as Dell capitalized on rapid and significant component price increases. Early in fiscal 1997, component prices dropped almost as much as 10% per month, 20% in total for the second quarter! Dell benefited almost immediately from price reductions while its competitor, burdened with higher levels of over-priced parts, lagged by as much as sox months. For commodity parts like keyboards, Dell established global relationships with just a few suppliers to secure better terms, and reduced inventory levels by requiring suppliers to hold inventory destined for Dell until the company, embracing a just-in-time inventory philosophy, needed parts for production. Days Sales of Inventory (DSI) was reduced from 31 days, fourth quarter 1996, to just 13 days a year later! Dell ended 1997 with 41% less inventory than the year before. Compared to the projections in Exhibit TN-4 (adjusted for actual sales in 1997), Exhibit TN-8 shows that inventory was $378 million less then the projection based upon 1996 sales ratios.
Dell reduced the number of days to collect payment from customers by 5 days in 1997. It installed a new third party accounts receivable software program that provided its collectors with enhanced account information, specifically why customers weren’t paying. While the company’s accounts receivable year-end balance increased $200 million from 1996 to 1997, Days Sales Outstanding (DSO) actually fell from 42 to 37 days comparing fourth quarters. Exhibit TN-8 shows that accounts receivables were $161 million less than the projection. In 1997, Dell’s inventory and accounts receivables balances combined remained unchanged because of improved asset efficiency. Had the company continued to operate at 1996 efficiency rates, Dell would have needed over $500 million additional current assets to generate 47% in incremental sales in 1997.
Equal to its asset efficiency gains, Dell substantially lengthened its Days Payables Outstanding (DPO). The manager of Dell’s asset management department conceded that in 1996 Dell was paying vendors prior to negotiated terms because of a lack of attentiveness between supply receipt and payment dates. In quarter 4 of 1997 Dell paid its suppliers, on average, in 54 days – an increase of 64% , or 21 days, from a year earlier. Accounts payables increased nearly $500 million in 1997, providing Dell with an additional source of growth funding. Exhibit TN-8 shows that accounts receivables were $357 million more than the projection.
Exhibit TN-9 shows that the improvements in Dell’s working capital resulted in a negative conversion cycle.
For 1997, Dell’s return on sales rose to 6.6%, up from 5.1% a year ealier. 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, gross margin was 21.5% versus 20.2% in 1996. Operating margin also improved as operating expense as a percent of sales fell 12.3% from 13.1% a year earlier. Net profits totaled $518 million, of which $120 million was the result of improved margins over 1996. This additional income provided internal financing for Dell’s growth.