Dell’s Working Capital

Dr. C. Bulent Aybar

Professor of International Finance
 Dell Computer Corp.

• Dell Computer Corporation 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 investment
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.

© Dr. C. Bulent Aybar

 Dell’s Growth vs Industry

Calendar Year Dell Industry

1991 63% -2%
1992 126% 7%
1993 43% 15%
1994 21% 37%
1995 52% 31%
 Days Supply of Inventory
1993 1994 1995

Dell Computer 55 33 32

Apple Computer 52 85 54

Compaq Computer 72 60 73

IBM 64 57 48

One way 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.
Additional Inventory at Compaq’s DSI=
= (Dell’s Daily Purchases)x(Compaq’s DSI – Dell’s DSI)
=(($2,737/360)x(73-32)
= $312 million
This $312 million, in perspective, represents 59% of Dell’s cash & short-term
investments, 48% of its stockholder equity, and 209% of its 1996 net income.
 Working Capital and Cash to Cash Cycle
DSI DSO DPO CCC
Q193 40 54 46 48
Q293 44 51 55 40
Q393 47 52 51 48
Q493 55 54 53 56
Q194 55 58 56 57
Q294 41 53 43 51
Q394 33 53 45 41
Q494 33 50 42 41
Q195 32 53 45 40
Q295 35 49 44 40
Q395 35 50 46 39
Q495 32 47 44 35
Q196 34 47 42 39
Q296 36 50 43 43
Q396 37 49 43 43
Q496 31 42 33 40
DSI (Days Sales of Inventory) = Net Inventory / (Quarterly COGS/90).
DSO (Days Sales Outstanding) = Net Accounts Receivables / (Quarterly Sales/90).
DPO (Days Payables Outstanding) = Accounts Payables / (Quarterly COGS/90).
CCC (Cash Conversion Cycle) = DSI + DSO – DPO.
 Other Advantages aside from the conservation of capital

• Dell’s low component inventory reduces obsolescence risk

and lowers inventory cost.
– Dell’s inventory was about 8.9% of its COGS while Compaq’s
inventory was about 20.3% of its COGS.
– If technological change reduced the value of inventory by 30%, Dell
would incur an inventory loss of about 2.7% of COGS and Compaq
would incur a loss of 6.1% of COGS (assuming the same COGS).
– The lower inventory losses for Dell imply higher profits. At Dell’s
1995 COGS of $2.7 billion, the effect of component price reductions
contributes about $93 million to profits ($2.7 billion x(6.1%-2.7%)).

© Dr. C. Bulent Aybar

• 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 model. Dell was able
to grow sales by offering faster systems at prices of
competitor’s slower machines.

© Dr. C. Bulent Aybar

 Risks Involved in Dell’s Business Model

• Dell’s build-to-order model and resulting low inventory had

some risks.
– Component shortages were a disadvantage of Dell’s aggressive
inventory model! Dell had order backlogs because of part
shortages.

• While revenue may have been lost due to cancelled or

delayed orders until supplies were available, the rapid
technological change made the advantages of Dell’s
approach outweigh the disadvantages.

© Dr. C. Bulent Aybar

 Funding 1996 Growth

• In 1995 total assets were 46% of sales (1,594/3,475). Short-

term investments were 14% of sales.
• If we assume the short-term investments were not required to
support operations, Dell would have required 32% of
increased sales in additional operating assets.
• Sales in 1996  $5,296m  an increase of $1,821m or
52% from 3,475m in 1995.
• So if Dell required an increase in operating assets as much as
32% of the increase in sales:
– $1.8bn x 0.32  $582m additional investment in operational assets
would be necessary!
© Dr. C. Bulent Aybar
 Dell’s Growth and Funding Needs

• If 1995 profit margins of 4.3% had held Dell would have

realized
$5,296 x 0.043 =$227 million

• in net income; the additional funding requirement would be:

$582-$227=$335m

• Note that this funding requirement assumes that liabilities

remain constant!
• If we allowed liabilities change proportionally, Dell would
have an excess funding of 139m.

© Dr. C. Bulent Aybar

 1995 Balance Sheet as a % of Sales Forecast for 1996 with Actual 1996 Sales
% of
29-Jan-95 Sales Fixed Liablilities Proportional Liabilities
Current Assets:
Cash 43 1.24% 66 66
Short Term Investments 484 13.93% 484 484
Accounts Receivables, net 538 15.48% 820 820
Inventories 293 8.43% 447 447
Other 112 3.22% 171 171
Total Current Assets 1,470 42.30% 1,987 1,987
Property, Plant & Equipment, net 117 3.37% 178 178
Other 7 0.20% 11 11
Total Assets 1,594 45.87% 2,176 2,176
Additional Funding Needed 355 (139)
Current Liabilities:
Accounts Payable 403 11.60% 403 614
Accrued and Other Liabilities 349 10.04% 349 532
Total Current Liabilities 752 21.64% 752 1,146
Long Term Debt 113 3.25% 113 172
Other Liabilities 77 2.22% 77 117
Total Liabilities 942 27.11% 942 1,436
Stockholders’ Equity:
Preferred Stocka 120 3.45% 120 120
Common Stocka 242 6.96% 242 242
Retained Earnings 311 8.95% 538 538
Other (21) -0.60% -21 (21)
Total Stockholders’ Equity 652 18.76% 879 879
Total Liabilities & Stockholder's
Equity 1,594 45.87% 1,821 2,315
 Dell’s Sustainable Growth Rate in 1995

NI(t)/S(t) S(t)/A(t-1) A(t-1)/E(t-1) % Retained SGR

Calculations using all assets
1995 4.3% 3.05 2.42 100.0% 31.6%
1996 5.1% 3.32 2.44 100.0% 41.7%
1997 Projected 5.1% 3.70 2.21 100.0% 41.9%
1997 Actual 6.7% 3.61 2.21 100.0% 53.2%

• 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 raises 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!
 Adjusted Balance Sheet
January 28, January 29, January 30,
1996 1995 1994
Current Assets:
Cash 55 43 3
Accounts Receivables, net 726 538 411
Inventories 429 293 220
Other 156 112 80
Total Current Assets 1,366 986 714
Property, Plant & Equipment, net 179 117 87
Other 12 7 5
Total Assets 1,557 1,110 806

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
Common Stocka 430 242 NA
Retained Earnings 570 311 NA
Other (33) (21) NA
Total Stockholders’ Equity 382 168 137
1,557 1,110 806
 Profit & Loss

Fiscal Year 1996 1995 1994 1993 1992

Sales $5,296 $3,475 $2,873 $2,014 $890
Cost of Sales 4,229 2,737 2,440 1,565 608
Gross Margin 1,067 738 433 449 282
Operating Expenses 690 489 472 310 215
Operating Income 377 249 (39) 139 67
Financing & Other Income 6 (36) 0 4 7
Income Taxes 111 64 (3) 41 23
Net Profit 272 149 (36) 102 51

Adjusted Asset Turnover and Leverage Ratios for 1995:

AT(1995)=Sales(t)/TA(t-1)=3,475/806=4.31
Leverage =TA(t-1)/Equity(t-1)=806/137 =5.88
What Happens to SGR if we exclude Short Term Investments
NI(t)/S(t) S(t)/A(t-1) A(t-1)/E(t-1) % Retained SGR

1995 4.3% 4.31 5.88 100.0% 108.8%

1996 5.1% 4.77 6.61 100.0% 161.9%

To gauge the impact of these short-term investments on sustainable growth, we recalculate the
sustainable growth rate adjusting 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.

After a crude adjustment , sustainable growth rate for 1995 turns out to be about 109%,
which is well above its actual growth rate. Thus, Dell could finance substantial growth
without increasing leverage or obtaining more equity.
 Dell’s Actual Funding of Its Growth

Current Assets: 29-Jan-96Fixed Liablilities Variance

Cash
Short Term Investments
55
591
66
484
(11)
107
DSO improved by 5 days
Accounts Receivables, net 726 820 (94) over the prior year as
Inventories 429 447 (18)
Other 156 171 (15) accounts receivable balance
Total Current Assets 1,957 1,987 (30)
Property, Plant & Equipment, net 179 178 1
as a percent of sales dropped
Other 12 11 1 to 13.7% from 15.2%.
Total Assets 2,148 2,176 (28)
355
Current Liabilities: - -
Accounts Payable 466 403 63
Inventory levels as a percent
Accrued and Other Liabilities
Total Current Liabilities
473
939
349
752
124
187
of sales also decreased
Long Term Debt 113 113 - slightly as DSI improved by
Other Liabilities 123 77 46
Total Liabilities 1,175 942 233 one day to 31
Stockholders’ Equity: - -
Preferred Stocka 6 120 (114)
Common Stocka 430 242 188 Overall, assets other than
Retained Earnings 570 538 32
Other (33) (21) (12)
short-term investments fell
Total Stockholders’ Equity 973 879 94 from 32% of sales in 1995 to
2,148 2,176 (28)
29% of sales in 1996.
 1996 Projections vs. Realizations

• As a result of improved efficiency Dell reduced current

operating assets by $30m.
• Dell increased its current liabilities by $187 million. As a
percent of sales, current liabilities fell from 21.6% in 1995 to
17.7%.
• Accounts payable was 8.8% percent of sales, a decrease of
nearly 3%. In fact, during Q4 1996, Dell paid its suppliers 11
days faster than a year earlier.
• Despite 1% erosion in gross margin, Dell’s profit margin
improved from 4.3% to 5.1%

© Dr. C. Bulent Aybar

• In short, Dell internally funded a 52% growth in sales largely
by increasing its asset utilization efficiency and profitability.
• We could repeat the analysis to see if Dell will be able to
grow at 50%; as we have shown before, provided that Dell
maintains or improves its efficiency and or profitability, it
can grow at high double digit rates.
• Since this growth is below its SGR, it is likely to produce
substantial cash surplus,
• Dell could consider value creating acquisitions or share
repurchases to return cash to shareholders.

© Dr. C. Bulent Aybar

 1997 Projections Under Alternative Scenarios
Fixed
Current Assets: Year Ended 01/28/96 Actual Percent of Sales Liabailities Proportional Liabilities Debt Repaid & Repurchase
Cash 55 1% 83 83 83
Short Term Investments 591 11% 591 591 591
Accounts Receivables, net 726 14% 1,089 1,089 1,089
Inventories 429 8% 644 644 644
Other 156 3% 234 234 234
Total Current Assets 1,957 37% 2,640 2,640 2,640
Property, Plant & Equipment, net 179 3% 269 269 269
Other 12 0% 18 18 18
Total Assets 2,148 41% 2,927 2,927 2,927
Additional Funding Needed 373 (214) 986
Current Liabilities:
Accounts Payable 466 9% 466 699 466
Accrued and Other Liabilities 473 9% 473 710 473
Total Current Liabilities 939 18% 939 1,409 939
Long Term Debt 113 2% 113 170 0
Other Liabilities 123 2% 123 185 123
Total Liabilities 1,175 22% 1,175 1,763 1,062
Stockholders’ Equity:
Preferred Stocka 6
Common Stocka 430
Retained Earnings 570
Other (33)
Total Stockholders’ Equity 973 18% 1,378 1,378 878
2,148 41% 2,553 3,141 1,940

Third column assumes $500m Stock repurchase and $113mDebt repayment

 A Short Exposition on Analytics of Sustainable Growth

p=profit margin
t=TA/Sales
L=D/E Ratio
d= payout ratio
(1-d)=Retention
Ratio

Source: How Much Growth Can a Firm Afford, R. C. Higgins, Financial Management, Fall 1977
 Analytics of growth…

• Assume that sales grow from t to t+1 by s

• This means that assets should grow by t x s which is the
left hand side increment in the assets
• The increase in the assets should be matched with increase in
retained earnings and an additional amount of debt that
would not change D/E ratio:
• Addition to R/E= p x (S+ s) x (1-d)
• Addition to debt preserving capital structure=
New Debt =p x (S+ s) x (1-d) x L

© Dr. C. Bulent Aybar

 Reorganize to get SGR…..

• T x s = p x (S+ s) x (1-d) + p x (S+ s) x (1-d) x L

• T x s = p x (S+ s) x (1-d) x (1+L)
• T x s = [p x s x (1-d) x (1+L)]+[p x S x (1-d) x (1+L)]
• T x s - [p x s x (1-d) x (1+L)]=[p x S x (1-d) x (1+L)]
• [T - p x s x (1-d) x (1+L)] x s =[p x (1-d) x (1+L)] x S
• Solving for s/S produces:
s (1  L)  p  (1  d ) (1  L)  p  R
g *  SGR   
S [T  (1  L)  p  (1  d )] [T  (1  L)  p  R ]

• where R=(1-d)
© Dr. C. Bulent Aybar
 Recap: Managing Growth

• We simplify and approximate SGR as

g=(1-d)x(NI/Sales)x(Sales/TA)x(TA/Equity) or
simply as
g=Retention Ratio x ROE
• SGR is the rate of growth that can be achieved by preserving
– Net Profit Margin
– Asset Turnover
– Financial Leverage (=TA/Equity)
– Retention Ratio

• SGR=RR x ROE or SGR=RR x PM x AT x Leverage

© Dr. C. Bulent Aybar