Case 2 - Dell s Working Capital PDF

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Case 2 - Dell’s Working Capital Memo From: Maxime Gauthier-Grace (260611276); Samuel Hodhod (260696304); Clement Lai (260665485); Francis Poirier-Cloutier (260690546); John Poole (260655638); Natali Yerokhina Mazer (260744560) Subject: Dell’s Working Capital - Financing Future Growth Problem: Over the last few years, Dell Computer Corporation (“Dell”) has experienced continuous increases in sales, regularly outpacing the rest of the computer industry. In the most recent fiscal year of 2016, Dell achieved an impressive sales growth of 52%, relative to the industry benchmark of 31%. With industry analysts anticipating the personal computer market to grow 20% annually over the next 3 years, Dell is expected to continue its recent trend of strong performance. Nevertheless, inventory shortages have limited Dell’s full growth potential these past few years. Although their build-to-order inventory system has resulted in an incredibly efficient asset turnover, this strategy also limits the company’s sales when consumer demand exceeds the supply of inventory on hand. As a result, Dell must devise a plan for how to better manage and finance its future growth.

Options: 1. Status quo: no change in current management of working capital 2. Finance future growth internally 3. Finance future growth externally through the use of short-term liabilities Recommendation: Given Dell’s current financial position, as well as the external funding needed to finance their projected growth, Dell should finance its growth and inventory through the use of short-term liabilities. More specifically, Dell should do so by extending their Days Payable Outstanding, which results in an interest-free source of funding. Additionally, Dell should adopt an EOQ inventory management system in order to minimize total inventory costs, which will also decrease the total amount of liabilities Dell requires to sustain their growth moving forward.

Analysis

Funding Requirements: Is external funding needed? In order to assess the amount of funding Dell must have on hand to finance their growth, we projected a pro-forma income statement and balance sheet for the fiscal year of 1997 using the information available, as well as several key assumptions. Firstly, we looked at Dell’s sales growth performance relative to the industry over the past 3 years, as this was when Dell shifted its focus from exclusively growth, to include profitability and liquidity policies. Since then, Dell has outperformed the industry on average by a multiple of 1.71. Given that industry analysts expect the personal computer industry to grow by 20% annually, we applied this multiple to the industry benchmark to forecast a growth rate for Dell of 34.29% (See Appendix I). Using this growth rate, Dell is expected to produce sales of $7.112 billion in 1997. Next, we applied the Percent of Sales Method using to each income statement item to forecast a pro forma income statement for 1997 (See Appendix II). Rather than taking multiple data points as a benchmark, only 1996 percentages were taken into consideration to better reflect the current operational conditions of the firm. Through this projection, net income for 1997 was estimated to be $357.22 million. Similarly, the same method was applied to common-size each of Dell’s asset accounts, as well as accounts payable and accrued and other liabilities, which we assumed to grow with sales. The remaining balance sheet items were assumed to have remained constant from 1996 to 1997 as a policy, with retained earnings being the sum of 1996’s year end retained earnings and 1997’s forecasted net income. Under these assumptions, it was determined that Dell would require external funding of $57.38 million in order to finance the assumed 34.29% growth. As a result, Dell would require either a change in policy, or external funding in order to finance this growth, eliminating the possibilities of option 1 and 2. Working Capital The net working capital has increased by an average of 42% per year in the past two years, driven primarily by sales growth (See Appendix III). Both current assets (approximately 40% of sales) and current liabilities (approximately 20% of sales) have been positively correlated with net sales, growing as a proportion of sales. This shows that Dell has not changed the structure of its short-term assets and liabilities to match the company growth. However, the company holds only 1% of its sales in cash (as of 1996) and is at least doing a great job of continuing to reinvest its earnings into potential opportunities rather than simply allowing funds to sit as cash. Looking at the quarterly performance of Dell in recent years, we can see a similar trend: the working capital of the company has seen a net improvement despite some quarterly variations. The Days Sales Outstanding (DSO) has decreased from a quarterly high of 58 (Q194) to 42 (Q496); Days Sales of Inventory (DSI) has decreased similarly from 55 (Q194) to 31; and the Cash Conversion Cycle (CCC) has decreased from 57 (Q194) to 40 (See Appendix IV). Again, the key noticeable problem is the change in Days Payables Outstanding: a steady decrease from 56 days (Q194) to 43 days (Q396) and then a sharp

decrease to 33 days (Q496). By paying their suppliers so quickly, Dell is giving up an interest-free financing opportunity, with its only net benefit being potentially improved relations with its suppliers. Financially, this is irresponsible, as assuming that there is no foregone discounts, then there would be no cost to increase the days payable outstanding. By extending the payback period back to their historical average of 43 days from the most recent quarter of 33 days, an additional $157 million of funding is generated (See Appendix V). In doing so, Dell can source the $51 million of external funding needed to fuel their expected growth without any additional costs. However, the major underlying assumption here is that there is no penalty for extending the payback period back to the historical average. If this is not the case, Dell should finance their EFN using short-term borrowing. Ratio Analysis Profitability Overall, Dell’s performance with regards to profitability has been on the rise. Net profit margin has increased from -1.25% in 1994 to 5.14% in 1996, which just exceeds the company’s target of 5% (See Appendix VI). Moreover, Dell’s ROA has increased from 10.90% in 1995 to 14.54% in 1996 and within a similar timeframe ROE has increased as well from 26.54% to 33.48% (See Appendix VI). It is clear that, on all metrics of profitability, Dell has been performing exceptionally well. However, although these 1996 results are favourable, Dell has suffered from component shortages. Thus, by correcting this inventory mismanagement through the implementation of an EOQ system, Dell could yet become even more profitable. Liquidity In recent years, Dell has demonstrated their ability to meet short-term financial obligations. This can be observed with their current ratio, which has increased from 1.95 in 1994 to 2.08 in 1996 (See Appendix VI). Furthermore, Dell’s quick ratio has also been steadily increasing as it reached 1.63 in 1996, demonstrating Dell’s ability to pay off shortterm liabilities without relying on the sale of inventories (See Appendix VI). Although Dell has been maintaining healthy liquidity in recent years, their days of purchases in accounts payable has diminished significantly from 52.35 in 1995 to 38.97 in 1996 (See Appendix VI). This once again reaffirms that Dell is paying its suppliers much quicker and as a result, are missing out on a potential lucrative source of funding. Financial Leverage Dell’s financial leverage has been on the decline. In fact, their debt ratio has fallen from 0.59 in 1994 to 0.55 in 1996, and their debt-to-equity ratio has dropped from 1.44 in 1995 to 1.21 in 1996 (See Appendix VI). It is clear that when it comes to financing, Dell does not have an overreliance on debt. Given these relatively low measures of financial leverage, it is possible for Dell to take on more debt without risking default. More specifically, they could extend their Days Payable Outstanding (DPO) and as a result, benefit from an interest-free

source of funding. However, this is assuming there is no discount being foregone by increasing the DPO. Inventory Management Dell holds significantly less inventory than its competitors. From 1993 to 1995, its days supply of inventory decreased from 55 days to 32 days, while its closest competitor, IBM, still held 48 days supply of inventory by 1995. As a result, Dell’s current attitude towards inventory management is clearly to order less inventory, more frequently in order to minimize holding costs. However, in doing so, Dell runs the risk of inventory shortage, which occured in the last quarter of 1996. Due to their close proximity to their component suppliers, we recommend that Dell sticks with their just-in-time system for their work in progress inventory. However, by switching to an Economic Order Quantity (EOQ) inventory management system, Dell will be able to minimize costs while maintaining enough inventory to meet average demand. Through the EOQ model, total inventory costs are minimized, not just the holding costs which Dell is currently focusing on. Additionally, by placing orders consisting of the average demand on top of a level of safety stock, Dell will be able to better manage fluctuations in demand, while keeping additional carrying costs low. However, this model must be monitored to determine the optimal quantity, and adjustments should be made if necessary. This is because maintaining too much inventory puts Dell at risk of inventory write-offs due to obsolescence, which occured in April 1993, when Dell sold off $76 million of excess inventory. Overall, the EOQ model will help Dell better manage demand, while maintaining, if not improving, their low-cost inventory policy.

Appendix Appendix I: Growth rate calculations Growth Assumptions (Calendar Year) Dell

Industry Relative Ratio

1991

63%

-2%

(Old Policy)

1992

126%

7%

(Old Policy)

1993

43%

15%

2.867

1994

21%

37%

0.568

1995

53%

31%

1.710

Average Performance Multiplier 1996/1997/1998E

1.715 34.29%

20%

1.715

Appendix II: Proforma financial statements (in millions of $) Profit & Loss Statement

Fiscal Year

1992

1993

1994

1995

1996

1996 % of Sales

1997E

Sales

$890.00

$2,014.00

$2,873.00

$3,475.00

$5,296.00

100.0%

$7,112.14

Cost of Sales

$608.00

$1,565.00

$2,440.00

$2,737.00

$4,229.00

79.9%

$5,679.24

Gross Margin

$282.00

$449.00

$433.00

$738.00

$1,067.00

20.1%

$1,432.90

Operating Expenses

$215.00

$310.00

$472.00

$489.00

$690.00

13.0%

$926.62

Operating Income

$67.00

$139.00

-$39.00

$249.00

$377.00

7.1%

$506.28

Financing & Other Income

$7.00

$4.00

$0.00

-$36.00

$6.00

0.1%

$8.06

Income Tax

$23.00

$41.00

-$3.00

$64.00

$111.00

n/a

$149.06

Net Profit

$51.00

$102.00

-$36.00

$149.00

$272.00

n/a

$357.22

1994

1995

1996

1996 % of Sales

1997E

Cash

$3

$43

$55

1.0%

$73.86

ST Investments

$334

$484

$591

11.2%

$793.67

A/R

$411

$538

$726

13.7%

$974.97

Inventories

$220

$293

$429

8.1%

$576.12

Other

$80

$112

$156

2.9%

$209.50

$1,048

$1,470

$1,957

n/a

$2,628.11

Balance Sheet

Fiscal Year

Current Assets:

Total Current Assets

Property, Plant, Equipment

$87

$117

$179

3.4%

$240.38

Other

$5

$7

$12

0.2%

$16.12

Total Assets

$1,140

$1,594

$2,148

n/a

$2,884.61

A/P

$0

$403

$466

8.8%

$625.80

Accrued and Other Liabilities

$0

$349

$473

8.9%

$635.20

Total Current Liabilities

$538

$752

$939

n/a

$1,261.01

Long Term Debt

$100

$113

$113

n/a

$113.00

Other Liabilities

$31

$77

$123

n/a

$123.00

Total Liabilities

$669

$942

$1,175

n/a

$1,497.01

Preferred Stock

$0

$120

$6

n/a

$6.00

Common Stock

$0

$242

$430

n/a

$430.00

Retained Earnings

$0

$311

$570

n/a

$927.22

Other

$0

-$21

-$33

n/a

-$33.00

Total Stockholders' Equity

$471

$652

$973

n/a

$1,330.22

Total Liabilities & S/E

$1,140

$1,594

$2,148

n/a

$2,827.23

Current Liabilities

Shareholders' Equity

EFN

$57.38

Appendix III: Change in Net Working Capital

Appendix IV: Working Capital Financial Ratios for Dell

Q193

DSI

DSO

DPO

CCC

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

Appendix V: Days Payable Outstanding (Source of Funding) DPO Calculations When DPO = 33, A/P = DPO = 43, A/P = Differences (Extra Funds Available) = Appendix VI: Financial Ratios...