Inputs From Income Statement: 1993 $1,731.7 1,460.8 1994 2,701.2 2,343.7 1995 3,676.3 3,060.5 1996 5,035.

2 4,071.6 1997 6,293.7 5,217.2 1998 7,467.9 5,921.7 1999 8,645.6 6,745.7

Net sales Cost of sales

Inputs From Balance Sheet: 1993 Current Assets: Accounts receivable Inventories Other current assets Deferred income taxes Non-Interest Bearing Current Liabilities: Accounts payable Accrued expenses Accrued royalties Other accrued liabilities 126.3 25.0 51.7 47.4 183.3 57.8 85.8 18.2 235.1 109.0 123.4 44.3 411.8 190.8 125.3 56.9 488.7 271.3 159.4 70.6 718.1 415.3 167.9 117.1 898.4 609.1 153.8 142.8 170.2 177.5 20.5 0.0 252.9 120.2 37.1 0.0 405.3 224.9 66.6 0.0 449.7 278.0 74.2 0.0 510.7 249.2 152.5 0.0 558.9 167.9 172.9 0.0 646.3 191.9 522.2 0.0 1994 1995 1996 1997 1998 1999

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 noninterest 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 214 29.9 252.9 120.2 37.1 0 654.2 183.3 3.8 57.8 85.8 18.2 348.9

1995 166.4 3.1 405.3 224.9 66.6 0 866.2 235.1 13.6 109 123.4 44.3 525.3

1996 516.4 0 449.7 278 74.2 0 1,318.30 411.8 15 190.8 125.3 56.9 799.8

1997 593.6 38.6 510.7 249.2 152.5 0 1,544.70 488.7 14 271.3 159.4 70.6 1,003.90

1998 1,169.80 158.7 558.9 167.9 172.9 0 2,228.20 718.1 11.4 415.3 167.9 117.1 1,429.70

1999 1,127.70 208.7 646.3 191.9 522.2 0 2,696.80 898.4 5.5 609.1 153.8 142.8 1,809.70

1995 74 405 225 67

1996 101 450 278 74

1997 126 511 249 153

1998 149 559 168 173

1999 173 646 192 522

770 235 109 123 44 512 259

903 412 191 125 57 785 118

1038 489 271 159 71 990 48

1049 718 415 168 117 1418 -369

1533 898 609 154 143 1804 -271

1994 119 -33 2,701 970 -3.40%

1995 259 139 3,676 975 14.30%

1996 118 -141 5,035 1,359 -10.30%

1997 48 -70 6,294 1,259 -5.50%

1998 -369 -418 7,468 1,174 -35.60%

1999 -271 98 8,646 1,178 8.30% -6.60%

Working Capital Analysis 1993 34.6 170.2 177.5 20.5 402.9 126.3 25.0 51.7 47.4 250.4 152.5 1994 54.0 252.9 120.2 37.1 464.3 183.3 57.8 85.8 18.2 345.1 119.2 1995 73.5 405.3 224.9 66.6 770.3 235.1 109.0 123.4 44.3 511.7 258.6 1996 100.7 449.7 278.0 74.2 902.7 411.8 190.8 125.3 56.9 784.7 118.0 1997 125.9 510.7 249.2 152.5 1,038.3 488.7 271.3 159.4 70.6 989.9 48.4 1998 149.4 558.9 167.9 172.9 1,049.1 718.1 415.3 167.9 117.1 1,418.3 -369.2 1999 172.9 646.3 191.9 522.2 1,533.3 898.4 609.1 153.8 142.8 1,804.2 -270.9

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

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

1993 152.5

1994 119.2 -33.3 2,701.2 969.5 -3.4%

1995 258.6 139.4 3,676.3 975.1 14.3%

1996 118.0 -140.6 5,035.2 1,358.9 -10.3%

1997 48.4 -69.6 6,293.7 1,258.5 -5.5%

1998 -369.2 -417.6 7,467.9 1,174.2 -35.6%

1999 -270.9 98.3 8,645.6 1,177.6 8.3% -6.6%

1,731.7

Cash Conversion Cycle Analysis 1994 28 23 24 27 1995 32 20 24 28 1996 31 22 29 24 1997 27 18 31 14 1998 26 13 37 2 1999 25 10 43 (8)

add: Days sales outstanding add: Days in inventory less: Days payable outstanding Cash conversion cycle