Dell’s Working Capital
3/27/13 Dell Working Capital 1. How was Dell’s working capital policy a competitive advantage? Dell’s core strategy in the 90’s, build to order business model, allowed the firm to work with minimum finished goods and work-in-process (WIP) inventory. As a result, Dell maintained low inventory costs and permitted the company to adjust to technological innovations in the market. Dell’s WIP and finished goods inventory as a percent of total inventory was about 10%-20%, compared to the industry rate of 50%-70%.
This led the company have low accounts payable, low cash conversion cycle, and high inventory turnover (Dell DSI 32 days vs. 58 days). As Dell’s computers were assembled after the company received the sale order and, as the rate of innovation is high, by keeping low inventory levels, the company could easily adjust to the new technology whereas the competition incurs in high depreciation rate of approximately 40% per year on old hardware components (Source Dell Website) for old.
Additionally, if any component was factory flawed, as in 1994 with the Pentium chip, the company could quickly manufacture computers with the new updated flawless chip. Moreover, the company could reach new technology or components to market in an average of 35 days compared to 100 days by the competition. This helped Dell to take first mover advantage. 2. How did Dell fund its 52% growth in 1996? The sales increased 52% owing to growth in sales of Pentium processor. Calculating the increase in Cash, Working Capital and Fixed Assets from 1995 to 1996, we can calculate the funding requirement for 1996: 1996 | ?
Cash | ? Working Capital | ? Fixed Assets | Funding Requirement | $119 Mn | $181Mn | $62Mn | To match the funding requirement, retained earnings grew by 83% ($259Mn), other liabilities by $46Mn and common stock by $74Mn – Total $379 Mn. The internally generated funds were sufficient to fund its 1996 requirements – change in retained earnings and externally (liabilities & common stock). In addition, ratio of operating expenses to total sales in 1996 improved by 1% – reduced cost. Moreover DSI, SO, DPO reduced in 1996, when compared to 1995, which increased CCC and improved their working capital.
Asset turnover ratio had a marginal increase to 3. 40 from 3. 13. These factors show that Dell improved its efficiency. 3. Assuming Dell sales will grow by 50% in 1997, how might the company fund this growth internally? How much would working capital need to be reduced and/or profit margin increased? What steps do you recommend the company take? Projected Income Statement for 1997 Assumptions: Sales, COGS, Operating Expenses grew by 50% and other income $0 because we are not certain of any other additional income for 1997 (conservative projection). (Below mentioned figures are in $ Mn) | 1996 | ? | 1997 | Sales | 5,296 | 50% | 7944 | COGS | 4,229 | 50% | 6344 | Gross Margin | 1,067 | | 1600 | Operating Exp. | ,690 | 50% | 1035 | Operating Income | 377 | | 565 | www. termpaperwarehouse. com/print/Dell-Working-Capital/74941 1/3 3/27/13 Dell Working Capital Other Income | 6 | | 0 | Tax | 111 | | 164 | Net Income | 272 | | 401 | Assuming that DSI, DSO, DPO didn’t change in 1997, equal to 1996, working capital change will also increase at the rate of sales increase, which 50%. This means that there is no change in efficiency. We also assumed that other liabilities will remain constant. 1996 | 1997 | Change | Cash | 55 | 258 | 203 | Short term Investment | 591 | 591 | 0 | Accounts Receivable | 726 | 1,089 | 363 | Inventories | 429 | 644 | 215 | Other Liabilities | 156 | 156 | 0 | Current Assets | 1957 | 2,738 | 784 | PPE | 179 | 269 | 90 | Other | 12 | 12 | 0 | Total Assets | 2,148 | 3,019 | 871 | Accounts Payable | 466 | 699 | 233 | Accrued Expenses | 473 | 710 | 237 | Current Liabilities | 939 | 1409 | 470 | Long Term Debt | 113 | 113 | – | Other | 123 | 123 | – | Preferred Stock | 6 | 6 | – | Common Stock | 430 | 430 | – | Retained Earnings | 570 | 971 | 401 | Other | (33) | (33) | – | Total Liabilities + OE | 2,148 | 3,019 | 871 | Net Profit | 401 | Less change in working capital | 108 | Net cash flow from operating activities | 293 | Increase in PPE | 90 | Net Cash flow from investment activities | 90 | Net Cash flow from financing activities | – | Cash Opening Balance | 55 | Change | 203 | Closing Balance | 258 | The total funding requirement in 1997 is $401Mn. The actual requirement for Dell to sustain its growth target is $90+$108 = $198Mn. The remaining cash is incremental additional cash which is earned through operations, which can be invested as an asset (liquid investments). 4. How would your answers to Question 3 change if Dell also repurchased $500 Mn of common stock in 1997 and repaid its long term debt?
The total amount of repurchase $500Mn and long term debt $113Mn is equal to $663Mn, which affects the net cash flow from financing activities. Total funding requirement is $663Mn + $90Mn (PPE) + $108Mn (WC) = $861Mn. Earnings from 1997, is $401Mn. We require an additional $460Mn ($861-$401) to fund www. termpaperwarehouse. com/print/Dell-Working-Capital/74941 2/3 3/27/13 Dell Working Capital repurchase and repay long term debt. Increasing revenues means increasing sales price (consumer price). This option might not be viable because increase in price will decrease number of units sold. We don’t know the relationship between quantity demanded and price. However, every 1% increase in sales increases gross profit by $80Mn.
In addition, operating expense will also increase due to increase in sales. This option might not be viable. Another option is to pay through accumulated cash and cash equivalents ($849Mn) to fund. However, this reduces the cash & its equivalents to $389Mn ($849Mn-$460Mn). This could be probable option; nevertheless Dell cannot increase its probable future expansion plan in 1998. In case, Dell has no future expansion plan, it is a possible option to lean Dell’s balance sheet. Most likely and sustainable option is to increase efficiency i. e. improve working capital. Dell can adjust its amount receivables, inventories and amount payable to have low working capital (or even negative working capital).
This can be achieved by reducing credit period to customers (such as cash & carry), increasing payable days to suppliers and reducing inventory carrying days. This will enable Dell to generate excess cash to fund its repurchase and repay long term debt. Dell had component shortage in 1996. Any increase in number of payable days to suppliers, will actually deteriorate the situation of supply. We will not increase payable days in our calculation. | DSI | Inventory | DSO | Receivable | Current | 36. 48 | 643. 5 | 49. 50 | 1,089 | Target | 25 | 420 | 25 | 662 | Incremental Cash | | 223. 5 | | 427 | Reducing DSI and DSO, we are able to achieve sufficient cash of $650. 5Mn to fund repurchase and repay long term debt. www. termpaperwarehouse. com/print/Dell-Working-Capital/74941 3/3