Applied Corporate Finance

class #2

Working Capital
Capital Employed

Paulo Soares de Pinho

Universidade Nova de Lisboa
 Working Capital

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 Working Capital
• In Accounting, Net Working Capital (NWC) is defined as the difference
between Current Assets and Current Liabilities
• In other words, it represents the amount of current assets that was
financed by long-term funds

Fixed Assets Equity

N
W LT
Current Assets C Liabilities
Current Liabilities

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 NWC requirements and the Operating Cycle

• The firms’ operating cycle generates a corresponding cash-cycle who

determines how much working capital is required to finance the firm’s
operations
purchase sale collection
$
inventory receivables

payables NWCR
$
payment

Cash conversion cycle (days)

NWCR = Inventories + Receivables - Payables (+ other)

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 Rethinking the balance Sheet

Financial Assets Operating Liabilities

(Cash & Marketable Securities)
(Payables + Accruals)

Operating Assets
Financial Liabilities
(Receivables + Inventories + Accruals)
(Bank Loans, Bonds, etc)

Fixed Assets
Shareholders’ Equity

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 Reorganised balance Sheet

Net Working Capital Requirements

Net Debt
Operating Asets minus Operating
Liabilities Financial Debt minus Financial Assets

Fixed Assets
Shareholders’ Equity

Capital Employed = FA + NWCR = Net Debt + Equity

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 How does capital employed relate with company’s value?

Benefit from Capital Employed CAPITAL EMPLOYED Cost of Capital Employed

Net Debt
Future Cash Flows Capital Cost of debt (RD)
Employed RWACC
Operating Income (FA+NWCR) Equity Cost of Equity (RE)

• EV is thus the present value of the future operating cash flows generated by the firm’s operating
assets (FA+NWCR) discounted at the appropriate wacc; this is why EV = Net Debt + Equity
• Annually, the firm’s operating income (after taxes) must be sufficient to pay for the cost of funding
the company’s operating assets
• Value is only generated, on a yearly basis, if the return generated by these assets is higther than the
cost of funding them

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 EV and CE

CAPITAL EMPLOYED ENTERPRISE VALUE

Net Debt Net Debt

Capital
Employed

(FA+NWCR) Equity EV Equity

(book value)
(market
value)
Value created (cumulative NPV)

EV is the present value of the future cash flows generated

by the firm’s investment in capital employed

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 Return on Capital Employed (ROCE / ROIC)
• Also sometimes designated as return on invested capital (ROIC) measures the return
generated by the firm’s operating assets:
OperatingProfitnetoftaxes
ROCE =
CapitalEmployed

• We may also compute ROCE* after tax = NOPLAT / CE

• In order to continuously being adding value, companies must generated a ROCE that
exceeds their cost of capital:
• ROCE* (after tax) > RWACC
• The annual contribution to value creation is designated EVA (Economic Value
Added), which is measured as follows:
• EVA = Operating Profit Net of Taxes* – Capital Employed × RWACC
(*) Frequently designated as NOPLAT (net operating profits less adjusted taxes)

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 Case-study
Dell’s Working Capital

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 Main issues
1. Is Dell’s working capital management a source of competitive
advantage?
2. How did Dell fund its 1996 growth?
3. What is the firm’s ROCE?
4. What would have happened if the company kept its 1993 cash
conversion cycle?
5. May the firm sustain a 50% growth for 1997?

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 Competitive advantage
• Dell’s inventory management has substantial advantages over competitors’:
– Quicker to respond to shifts in demand; lower storage costs
– Quicker to adapt to new technologies
– Lower risk of obsolescency of finished goods (lower write-offs)
– Reduced levels of capital employed (and corresponding funding and cost of funds)
• Dell vs Compaq in late 1995
– If Dell had the same inventory management as Compaq, the increase in capital
employed would be:
• (73 - 32) × 2,737 / 360 = $312 million (48% of Dell’s equity!)

Dell’s COGS

Compaq’s DSI Dell’s DSI

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 Balance Sheet
Year Ended
January 28, January 29, January 30,
1996 1995 1994
Current Assets:
Cash 55 43 3
Short Term Investments 591 484 334
Accounts Receivables, net 726 538 411
Inventories 429 293 220
Other 156 112 80
Total Current Assets 1 957 1 470 1 048
Property, Plant & Equipment, net 179 117 87
Other 12 7 5
Total Assets 2 148 1 594 1 140

Current Liabilities:
Accounts Payable 466 403 NA
Accrued and Other Liabilities 473 349 NA
Total Current Liabilities 939 752 538
Long Term Debt 113 113 100
Other Liabilities 123 77 31
Total Liabilities 1 175 942 669
Stockholders’ Equity:
Preferred Stocka 6 120 NA
a
Common Stock 430 242 NA
Retained Earnings 570 311 NA
Other (33) (21) NA
Total Stockholders’ Equity 973 652 471
2 148 1 594 1 140

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 Year Ended
January 28, January 29, January 30,
1996 1995 1994
Net Working Capital Requirements
Accounts Receivables, net 726 538 411
Inventories 429 293 220
Other 156 112 80
(A) Total Current Operating Assets 1 311 943 711
minus
Accounts Payable 466 403 NA
Accrued and Other Liabilities 473 349 NA
(B) Total Current Operating Liabilities 939 752 538

(C) = (A) - (B) Total Net Workig Capital Requirements 372 191 173

Property, Plant & Equipment, net 179 117 87

Other 12 7 5
(D) Total Fixed Assets 191 124 92

(C) + (D) Total Capital Employed 563 315 265

Net Treasury
Cash 55 43 3
Short Term Investments 591 484 334
(E) Total Net Treasury -646 -527 -337

Long Term Debt 113 113 100

Other Liabilities 123 77 31
(F) Total Long Term Liabilities 236 190 131

(G) Total Stockholders’ Equity 973 652 471

(H) = (F) + (G) Total Long Term Funds 1 209 842 602

(I) = (E) + (H) Total Capital Employed 563 315 265

(H) - (D) Working Capital 1 018 718 510

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 Financing growth
Financing of Dell's Growing Capital Employed 1996 1995

Change in Capital employed

Change in Net Working Capital 181 18
Change in Fixed Assets 67 32
(A) Increase in Capital Employed 248 50

Increase in Net Debt

Change in Short Term Liabilities
Change in Long Term Liabilities 46 59
Change in Liquidity -119 -190
(B) Increase in Net Debt -73 -131

(C) Increase in Equity 321 181

(A) = (B) + (C) Increase in Capital Employed 248 50

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 How was growth financed
• The company was able to keep NWCR under control, by keeping the
cash conversion cycle around 40 days for most of 1996; this implied
$181 million on NWCR for that year
• The company was able to finance the $248 million increase of capital
employed via increase in equity ($321m), mostly via retained earnings
and partially via issuance of common stock (conversion of preferred
stock at a favorable price)
• The surplus, combined in an increase in long term liabilities of $46m,
resulted in an increase in liquidity investments of $119m

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 ROCE
Fiscal Year 1996 1995 1994
Sales $5 296 $3 475 $2 873
Cost of Sales 4 229 2 737 2 440
Gross Margin 1 067 738 433
Operating Expenses 690 489 472
Operating Income 377 249 (39)
Taxes on Operating Income @ 40% 151 100 -16
NOPLAT 226 149 -23

Capital Employed (eoy) 563 315 265

Capital Employed (avg) 439 290

ROCE (after tax) 51.5% 51.5%

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 What if 1993 ratios persisted?
Year Ended
January 28,
January 29,
January 30,
1996 1995 1994 Ratio
Net Working Capital Requirements
Accounts Receivables, net 765 502 415 52
Inventories 552 357 319 47
Other 156 112 80
(A) Total Current Operating Assets 1 473 971 814
minus
Accounts Payable 599 388 NA 51
Accrued and Other Liabilities 473 349 NA
(B) Total Current Operating Liabilities 939 752 538

(C) = (A) - (B) Total Net Workig Capital Requirements 534 219 276

Property, Plant & Equipment, net 179 117 87

Other 12 7 5
(D) Total Fixed Assets 191 124 92

(C) + (D) Total Capital Employed 725 343 368

Actual Capital Employed 563 315

Difference: 162 28

ROCE 42.3%

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 Financing 1997’s 50% growth

Fiscal Year 1997 1996

Sales $7 944 $5 296
Cost of Sales 6 344 4 229
Gross Margin 1 601 1 067
Operating Expenses 1035 690
Operating Income 566 377
Financing & Other Income 0 6
Income Taxes 215 111
Net Profit 351 272

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 Increase in 1997’s Capital Employed
1997 1996 1996 % of sales
Net Working Capital Requirements
Accounts Receivables, net 1089 726 13.7%
Inventories 644 429 8.1%
Other 234 156 2.9%
(A) Total Current Operating Assets 1 967 1 311 24.8%
minus
Accounts Payable 699 466 8.8%
Accrued and Other Liabilities 710 473 8.9%
(B) Total Current Operating Liabilities 1408.5 939 17.7%

(C) = (A) - (B) Total Net Workig Capital Requirements 558 372 7.0%

Property, Plant & Equipment, net 269 179 3.4%

Other 18 12 0.2%
(D) Total Fixed Assets 287 191 3.6%

(C) + (D) Total Capital Employed 845 563 10.6%

Increase in Capital Employed 282

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 Financial Equilibrium in 1997

Financial Equilibrium 1997

Capital Employed 845
Fixed Assets 287
Net Working Capital Requirements 558

Equity 1324

Net Debt -479

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