Inputs From Income Statement:

1993 1994 1995 1996 1997 1998 1999

Net sales $1,731.7 2,701.2 3,676.3 5,035.2 6,293.7 7,467.9 8,645.6
Cost of sales 1,460.8 2,343.7 3,060.5 4,071.6 5,217.2 5,921.7 6,745.7

Inputs From Balance Sheet:

1993 1994 1995 1996 1997 1998 1999

Current Assets:

Accounts receivable 170.2 252.9 405.3 449.7 510.7 558.9 646.3

Inventories 177.5 120.2 224.9 278.0 249.2 167.9 191.9
Other current assets 20.5 37.1 66.6 74.2 152.5 172.9 522.2
Deferred income taxes 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Non-Interest Bearing Current Liabilities:

Accounts payable 126.3 183.3 235.1 411.8 488.7 718.1 898.4

Accrued expenses 25.0 57.8 109.0 190.8 271.3 415.3 609.1
Accrued royalties 51.7 85.8 123.4 125.3 159.4 167.9 153.8
Other accrued liabilities 47.4 18.2 44.3 56.9 70.6 117.1 142.8
Online Tutorial #4: How Do You Calculate A Company's "Incremental Net Working
Capital" Needs?

Incremental investment in net working capital is another important value driver in a calculation
of shareholder value. This session focuses on where to find the data, how to calculate
historical working capital trends and how to project future working capital needs. As with
previous sessions, we will use Gateway, Inc., as of April 21, 2000, as a case study. Readers
who want to calculate working capital while reading this tutorial may wish to download the
accompanying spreadsheet.

What Does "Net Working Capital" Mean?

To understand what we mean by "net working capital," let's break this phrase down into its
component parts:

Net. This means we look at cash tied up in short term operating assets such as accounts
receivable and inventory, offset by non-interest bearing current liabilities such as accounts
payable.
Working. This means that we want to focus on cash tied up in short term operating assets.
Thus, working capital excludes long term capital required for, say, investment in Plant,
Property and Equipment (PP&E).
Capital. This means that we want to calculate the amount of cash that a company has to tie
up in working capital in order to run its business.

More specifically, for industrial companies, "net working capital" equals cash tied up by a
company's short term operating assets, netted against short term operating liabilities.

For any year, then, we add and subtract the following to calculate a company's net working
capital:

Required cash. We usually assume that a company needs to have some cash on hand to
run its business. We can estimate that sum as a fixed amount of cash, or an amount as a
percentage of sales. Thus, we add required cash to calculate working capital.
Accounts receivable (A/R). Accounts Receivable equals money owed to a company for
goods or services purchased on credit. As A/R grow, then, a company needs to tie up cash in
its business as it effectively lends this money out. Thus, we add accounts receivable to
calculate working capital.
Inventory. Any company selling a physical product will have to tie up cash in raw materials,
work-in-progress and finished goods inventory. Thus, we add inventory to calculate working
capital.

Other current assets. A company may have to tie up cash in other current assets, such as
insurance pre-payments. Thus, we add other current assets to calculate working capital.
Accounts payable. Accounts Payable equal bills from suppliers for goods or services
purchased on credit. A company benefits from accounts payable just like consumers benefit
from a charge card: you enjoy the merchandise now, and pay later. Thus, we subtract
accounts payable to calculate working capital.
 Deferred or Unearned Revenue. Some companies get paid in cash by their customers
before those companies deliver a promised product or service. As an example, you may
have purchased a warranty for a product, whereby you gave a company cash in advance for
a promised service: the ability to have that product replaced or fixed in the event it became
defective. Until the warranty ends, the company has the obligation to provide this service to
you, so it must recognize this cash received as a liability. Thus, we subtract deferred revenue
to calculate working capital.
Other non-interest bearing current liabilities. Various companies may have assorted non-
interest bearing current liabilities such as accrued wages, accrued expenses, accrued
royalties, or "other accrued liabilities." These non-interest bearing current liabilities generate
cash as they increase. Thus, we subtract other non-interest bearing current liabilities to
calculate working capital.

Case Study: Gateway, Inc., as of April 21, 2000

To calculate Gateway's net working capital, we first need to obtain the seven data points
described above from the company's historical SEC filings. (Click the relevant year to see
Gateway's balance sheet: 1995, 1996, 1997, 1998, or 1999.)

We have used these balance sheets to assemble a table that excerpts the current assets and
current liabilities portion of Gateway's balance sheet (below). We highlight those items that
directly enter into a calculation of net working capital:

Cash
Short-term investments
Accounts receivable
Inventories
Other current assets
Deferred income taxes
Current assets
Accounts payable
Notes payable
Accrued expenses
Accrued royalties
Other accrued liabilities
Current liabilities

After entering this data into the Inputs worksheet of the "Working Capital.xls" spreadsheet, we
can calculate net working capital by adding the relevant current operating assets and
subtracting the relevant current operating liabilities.

We do this in the table below:

Required cash (2% of sales)

A/R
Inventory
 Other current assets
Current operating assets
Accounts payable
Accrued expenses
Accrued royalties
Other accrued liabilities
Current operating liabilities
Net working capital

The last step of the analysis calculates how much cash Gateway typically ties up in working
capital to generate a dollar of new sales.

Net working capital

Incremental working capital
Sales
Incremental sales
Incremental working capital (% of sales)
Incremental working capital over last 5 years (%)

Here, we see that--unlike most companies--Gateway's net working capital tends to generate
cash from year to year. Over the five year period, we see that Gateway's net working capital
has fallen from $119 million to negative $271 million--a fall of $336 million--while sales have
increased from $2.7 billion to $8.6 billion--an increase of $5.9 billion. Over this period, then,
Gateway's "incremental working capital as a percentage of sales" equals negative $336 million
divided by $5.9 billion, or (6.6)%.

How Do You Project Future "Incremental Working Capital (%)"?

In Gateway's case, the company's historically tight working capital management leads us to
anticipate little future variability. We project incremental working capital as a percentage of
incremental sales to be approximately (5.0)%, similar to the company's historical average.

--------------------------------------------------------------------------------

Sidebar: Cash Conversion Cycle

In cases where working capital tends to be more volatile or trend in a particular direction, "cash
conversion cycle" analysis offers an intuitive way of thinking about, and projecting, working
capital. The cash conversion cycle quantifies the time between cash payment to suppliers and
cash receipt from customers.

The three components of the cash conversion cycle are as follows:

1. Days sales outstanding (DSO). The number of days between the sale of a product and the
receipt of a cash payment. The formula is: DSO = Days in year (360) / (Sales / Average
accounts receivable).
2. Days in inventory (DII). The number of days it takes for a company to convert its raw
material, work-in-progress and finished goods inventory into product sales. The formula is: DII
= Days in year (360) / (Cost of goods sold / Average inventory).

3. Days payables outstanding (DPO). The number of days between the purchase of an input
from a vendor and cash payment to that vendor. The formula is: DPO = Days in year (360) /
(Cost of goods sold / Average accounts payable).
1994 1995 1996 1997 1998 1999
214 166.4 516.4 593.6 1,169.80 1,127.70
29.9 3.1 0 38.6 158.7 208.7
252.9 405.3 449.7 510.7 558.9 646.3
120.2 224.9 278 249.2 167.9 191.9
37.1 66.6 74.2 152.5 172.9 522.2
0 0 0 0 0 0
654.2 866.2 1,318.30 1,544.70 2,228.20 2,696.80
183.3 235.1 411.8 488.7 718.1 898.4
3.8 13.6 15 14 11.4 5.5
57.8 109 190.8 271.3 415.3 609.1
85.8 123.4 125.3 159.4 167.9 153.8
18.2 44.3 56.9 70.6 117.1 142.8
348.9 525.3 799.8 1,003.90 1,429.70 1,809.70

1995 1996 1997 1998 1999

74 101 126 149 173
405 450 511 559 646
225 278 249 168 192
 67 74 153 173 522
770 903 1038 1049 1533
235 412 489 718 898
109 191 271 415 609
123 125 159 168 154
44 57 71 117 143
512 785 990 1418 1804
259 118 48 -369 -271

1994 1995 1996 1997 1998 1999

119 259 118 48 -369 -271
-33 139 -141 -70 -418 98
2,701 3,676 5,035 6,294 7,468 8,646
970 975 1,359 1,259 1,174 1,178
-3.40% 14.30% -10.30% -5.50% -35.60% 8.30%
-6.60%
Working Capital Analysis

1993 1994 1995 1996 1997 1998 1999

Required cash (2% of sales) 34.6 54.0 73.5 100.7 125.9 149.4 172.9
A/R 170.2 252.9 405.3 449.7 510.7 558.9 646.3
Inventory 177.5 120.2 224.9 278.0 249.2 167.9 191.9
Other current assets 20.5 37.1 66.6 74.2 152.5 172.9 522.2
Current operating assets 402.9 464.3 770.3 902.7 1,038.3 1,049.1 1,533.3

Accounts payable 126.3 183.3 235.1 411.8 488.7 718.1 898.4

Accrued expenses 25.0 57.8 109.0 190.8 271.3 415.3 609.1
Accrued royalties 51.7 85.8 123.4 125.3 159.4 167.9 153.8
Other accrued liabilities 47.4 18.2 44.3 56.9 70.6 117.1 142.8
Current operating liabilities 250.4 345.1 511.7 784.7 989.9 1,418.3 1,804.2

Net working capital 152.5 119.2 258.6 118.0 48.4 -369.2 -270.9

1993 1994 1995 1996 1997 1998 1999

Net working capital 152.5 119.2 258.6 118.0 48.4 -369.2 -270.9
Incremental working capital -33.3 139.4 -140.6 -69.6 -417.6 98.3

Sales 1,731.7 2,701.2 3,676.3 5,035.2 6,293.7 7,467.9 8,645.6

Incremental sales 969.5 975.1 1,358.9 1,258.5 1,174.2 1,177.6

Incremental working capital (% of sales) -3.4% 14.3% -10.3% -5.5% -35.6% 8.3%

Incremental working capital over last 5 years (%) -6.6%

Cash Conversion Cycle Analysis

1994 1995 1996 1997 1998 1999

add: Days sales outstanding 28 32 31 27 26 25
add: Days in inventory 23 20 22 18 13 10
less: Days payable outstanding 24 24 29 31 37 43
Cash conversion cycle 27 28 24 14 2 (8)