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Dell’s Working Capital Case Solution

Case Synopsis Over the last few years, Dell Computer Corporation has experienced continuous increases in sales, regularly surpassing industry growth rate. In the fiscal year of 1996, Dell achieved an impressive sales growth of 52%, relative to the industry growth rate 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-toorder 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.

Problem Identification Dell is facing inventory shortage due to their strict ‘Build-to-Order’ production model. Moreover, Dell is outpacing their sustainable growth rate (32%). So, Dell needs to implement appropriate working capital policy to support their growth (52%).

Options Dell has several options to maintain their growth rate. 

Maintaining current working capital policy



Financing future growth internally



Financing future growth externally through equity issue and borrowing



Financing growth through both internal and external sources

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Dell’s Working Capital Case Solution

Analysis Question 1: How was Dell’s working capital policy a competitive advantage? Dell’s build to order model enabled itself to produce computers within a short period of time while sourcing the components from the vendors in daily basis, which is eventually helped them to outpace the overall industry average Daily Supply of Inventory and Cash Conversion Cycle. Here are few points that made Dell’s a competitively innovative computer producers in times of industry consolidation and disruptions caused by flawed microprocessor vendor Intel. i)

Capital conservation due to lower inventory holding policy: Dell Computer Inc. used to maintain lower inventory ratio in compared to their competitors such as Apple Computer, IBM, Compaq etc. Dell’s stock turnover ratio in 1995 was 32 days which is lowest among their competitors. Whereas, Compaq’s stock turnover ratio in 1995 was 73 which is highest among the competitors. These numbers mean that Dell had to store inventories for 32 days before selling but their biggest competitor Compaq had to store it for 73 days. Dell Inc. strictly followed build-to-order production model which helped them to maintain lower stock turnover ratio. 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 in 1995 Inventory savings at Compaq’s DSI level calculation: We found from Exhibit 4 that, Dell’s cost of goods sold in 1995 was $2737 million. Dell’s annual stock turnover ratio was 32 days whereas Compaq’s annual stock inventory ratio 73 days. We can find the inventory savings amount in this way. Average inventory savings = (Compaq’s DSI – Dell’s DSI) * (Dell’s COGS/365) = (73-32) * ($2737/365) = $307.44 million It means Dell’s working capital policy helps to save $307.44 million. $307.44 million represents 47.55 % of Dell's cash and short term investments in year 1995, 47.14% of total stockholder's equity in year 1995 and 206% of the net profit in year 1995. Inventory savings at industry average method: The stock turnover ratios of Apple, Compaq and IBM are respectively 54, 73 and 48 days. Then, competitors average DSI is 52 days. Average inventory savings = (52-32) *($2737/365) = $149.97 million

ii)

Reduction of obsolescence risk and inventory cost: As Dell maintained lower inventory than their competitors, they could reduce inventory loss significantly. In 90’s personal computer market, when new technologies were introduced, it could lead to 30% reduction in component price. Let’s quantify it Dell’s inventory = Dell’s DSI * (Dell’s COGS/365) = 32* (2737/365) = $239.96 million 3

Dell’s Working Capital Case Solution

Compaq’s inventory= Compaq’s DSI * (Dell’s COGS1/365) = 73* (2737/365) = $547. 4 million If we calculate these two companies’ inventory as a percentage of cost of sales, that will be 8.7% for Dell and 20% for Compaq. If there is a chance of 30% price reduction, inventory loss will be 2.61% for Dell and 6% for Compact. So, comparative increase for Dell’s net profit in 1996 is equal to 1996’s Dell’s net profit times the difference between Dell and Compaq’s inventory loss which is$9.22 million. iii)

Dell’s Build-to-Order model: The industry practice back then was to make forecast of sales units of computers and making computer or assembling the components based on the forecast. The problem was that no one could actually predict the future or make a reasonable guess of the computer industry back then given the industry is growing at an unprecedented rate which is in some years in negative figures and double digit growth from year to year. From the situation described in the case no single year of industry growth can be traced with a forecast, for instance, the growth in 1991 was negative and a single digit growth next year which is at 7% rate. After the 1992, the growth took double digit rate and most interesting thing happened next year where the growth rate doubled within a year. So, every single competitors of the industry was forecasting the future sales and manufacturing computers based on the forecast

Image 1: Dell’s build to order model

The Dell Computer was managing working policy in a different way. They were a small company back in 1990s. They had been fearing the ongoing consolidation trends of the industry and opted for a different inventory management policy. They adopted the build to order model which yielded low finished goods and low work in process inventory balances. The idea of build to order model was to build the computers after receiving the orders instead of manufacturing or assembling the computers before and waiting for the buyers and selling receiving the orders. The 1We are assuming same COGS amount for both Dell and Compaq

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Dell’s Working Capital Case Solution

motive behind that was to keep less cash or near cash balances tied up in the inventory so that they can eventually survive the ongoing industry consolidation trends in early 1990s. If we want to check the industry scenario of early 1990s, Compaq, Apple and IBM’s finished goods inventory typically ranged from 50% to 70%. In contrast, the Dell Computers finished goods and work in process inventory ranged from 10% to 20%, which was more than fivefold lower than the industry average. Days Supply of Inventory (DSI)

Dell Computer Apple Computer Compaq Computer IBM

1993 55

YoY Efficiency 67%

1994 33

YoY Efficiency 3%

1995 32

Efficiency in Day Terms 1993 -1995 23 Days

52

-39%

85

57%

54

-2 Days

72 64

20% 12%

60 57

-18% 19%

73 48

-1 Days 16 Day

Table 1: Dell’s efficiency in terms of DSI

So, how did policy change serve as a competitive advantage for Dell Inc? Companies operating in the computer manufacturing industry back in 1990s used to maintain high levels of inventory to stock resellers and retail channels. As a consequence of that, they had to bear additional costs to maintain high levels of inventory and inventory soaked up additional working capital which can be used to foster additional growth. Dell was making computer based on orders from the customers. As a result, they had less working capital tied up in inventory and work in process goods. So, they can continue their business with lower than average industry working capital and can instantly respond to the market needs. The policy paid off greatly in 1995 when Dell became the first manufacturer of the industry to convert its major product line to the Pentium Technology. Because of its low finished goods inventory, Dell didn’t have to reconstruct their computer inventory when a major flaw of intel process got attention and they could readily respond to the situation as they didn’t have high levels of finished and working in process inventory. iv)

Sourcing Components on daily basis: Apple, IBM and Compaq, all top three computer manufacturer had high levels of working capital tied up in inventory. Back then, processor chip comprised about 80% of the cost of a PC. The truth about the technology market as a new technological improvement takes place the prices of components fell by an average of 30% a year. As the top shareholders of the computer manufacturing industry had high levels of inventory in their working capital, they had to deliver computers with older technology as they had to clear the existing computers made with older technology.

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Dell’s Working Capital Case Solution

But the reality was totally different for Dell Computer. As they used to collect components of computers from the suppliers in daily basis, they did not have to deliver computers with older technology. So, they can deliver what customers wanted instantly. Because of that, Dell became the first manufacturer of the industry to convert its entire major product line to the Pentium Technology and achieved volume production of systems with the new 120 mhz processor. Afterwards, they equipped the Microsoft Corporation’s new Windows 95 on the first day of launch. So, Sourcing components in daily basis helped Dell Computer to bring new technological improvement in the market at the shortest possible time.

Question 2: How did Dell fund its 52% growth in 1996? There were a couple of fundamental changes that effectively had direct impact on the growth of Dell Computer in 1996. To name a few, we would like to mention the combined shift towards liquidity, profitability, and growth instead of previously taken initiative of only focusing on growth. The liquidity and profitability improvement at the same time has funded the 52% growth in 1996. In terms of profitability improvements, we would like to check a few ratios of profitability to measure the year to year margins and returns based on various denominators. Fiscal Year Profitability Ratios:

1996

1995

1994

Net Profit Margin (Net Income/Revenue)

5.1%

4.3%

-1.3%

Previously Dell Computer had negative margin in the year 1994 when they had to exit the low margin indirect retail channel segment for the sake of achieving profitability. So, for exiting that segment they had to make a loss that year, as they had other plans for future. From the year 1995 to 1996, we see a significant improvement in the Net Profit Margin, where the margin reached at 5.1% in 1996 from 4.3% in 1995.Focusing on the high margin segments brought that level of net profit margin for Dell Computers in the year 1995 and 1996. Fiscal Year Profitability Ratios: Return on Assets (Net Income/Average Total Assets) Return on Total Capital (EBT/Average Total Capital) Return on Equity (Net Income/Average Total Equity)

1996

1995

14.5%

10.9%

41.4%

31.9%

33.5%

26.5%

The exit of low margin indirect retail channel had other impacts as well other than net profit margin improvement. The Return on Assets, the Return on Total Capital and Return on Equity 6

Dell’s Working Capital Case Solution

had significant improvement. Only because the significant improvement in sales and net profit margin. Fiscal Year Sales Growth

1996 52.40%

1995 20.95%

1994 42.65%

The 52.4% sales growth in the year 1996 brought 14.5% Return on Assets, 41.4% Return on Capital and 33.5% Return on Equity. A year before, in 1995, return on Assets were 10.9%, Return on Capital were 31.9%, Return on Equity were 26.5%. If we compare the last year, 1996’s growth with 1995’s growth, the improvement is significantly high.

Pe rcent of De l l Compute r Syste ms Sale s By M icroproce ss or 1 9 94 -19 9 6 486 Models

Pentium Models

Year

1%7%

92%

1994

29%

71%

1995

1996

386 Models

75%

25%

0%

0%

Percent

In 1994, Dell adopted the Pentium Model processors. The sales percentage of Pentium based processor rose two times from the year 1995 to 1996 from 29% to whopping 75%. Dell was the first company to bring its major product line to Pentium technology in the computer manufacturing industry, which brought the fortune of 52.4% sales growth fortune within a year to Dell Computer. Fiscal Year Return on Invested Capital (ROIC)

1996

1995

1994

35.8%

33.9%

-6.9%

EBIT(1-Tax)/(BV of Debt + BV of Equity-Cash) Later in 1995, Dell instituted goals on Return on Invested Capital and Cash Conversion Cycle improvement. They took steps to improve its internal capacity, forecasting, reporting and inventory control. They even hired seasoned managers to lead the company to the next level. The Return on Invested Capital percentages showed the improvement of Dell Computer’s year to year return on invested capital terms. We see a significant ROIC improvement in the year 1996 from 33.9% to 35.8% within a year. Fiscal Year Cash Conversion Cycle Quarterly Average

1996

1995

1994

41.25

38.50

47.50

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Dell’s Working Capital Case Solution

We averaged out the quarterly cash conversion cycle numbers to measure the year to year improvement. The average CCC was 47.5 days in 1994 and within a year it reached at 38.5 days in 1995. After that, in 1996, CCC rose to 41.25 days. We tried to investigate the possible reason, the quarterly average DPO reduced to 40.25 days from 44.75 days, which caused the CCC increase in 1996.

Fiscal Year Defensive Interval

1996 101.81

1995 120.50

1994 93.76

(Cash+ Marketable Securities+ Receivables)/Average Daily Expenditures Defensive interval ratio measures the liquidity that indicates the number days of average cash expenditures the firm could pay with its current liquid assets. For Dell Computer, the ratio reduced to 101.81 days in 1996, which was 120.5 in 1995. That was a sign that Dell Computer’s companywide metrics towards liquidity and profitability at the same time working, for instance, the company’s financial position remained liquid at the same time the ROIC rose to 35.8% keeping the Defensive Interval ratio significantly high. Few points on 52.4% sales growth of Dell Computer: I.

Companywide policy towards liquidity and profitability at the same time directly impacted its growth of 52.4% keeping all of its leading metrics suitably higher than before.

II.

Companywide metrics adoption to provide detailed profit and loss statements helped make timely and data driven decision to take steps towards liquidity and profitability at the same time.

III.

Low margin retail channel exit and being the first producer to convert major product line to the Intel’s Pentium Technology significantly contributed to the sales growth and profitability in 1996.

IV.

Sales growth could also be impacted by the new Microsoft Windows 95launch with the Dell Computer’s System at the same day.

V.

For keeping the growth and profit margin stable Dell Computer hired seasoned managers, though their direct impact were not quantified.

We can analyze the growth funding process in 3 steps. Firstly, we need to forecast how much funds Dell needed to sustain their growth. Secondly, we need to evaluate their sources of funds. Finally, we need to evaluate the impact of their growth financing with their actual balance sheet figure. However, we need to state the assumptions of our forecasting: 

Sales growth, g = 52%

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Dell’s Working Capital Case Solution



Cost of sales, operating expense and other expenses/income will be increased proportionately with sales amount.



Net working capital to sales ratio in 1995 was 18.45%. Same ratio will be maintained in 1996.



Debt ratio as a percentage of total assets in 1995 was 3.57%. Same ratio will be maintained in 1997considering only long-term debt.



Other liabilities are considered as a part of working capital.



No dividends will be declared.

i)

Total fund requirements: To determine how Dell funded its fiscal 1996 sales growth, we need to analyze how much fund Dell exactly needed to sustain such 52.4% growth in 1996. When we compare Dell’s performance in 1996 as compared to 1995, the Sale grew from $3475 million to $5296 million reporting a growth of 52.4%. However, the total assets in 1995 were $1594 i.e. 22.01% of sales and net working capital investment which is about 18.45% of sales. Thus, when the sales grow by 52%, total assets need to grow in a similar proportion of sales. Given the working capital ratio and fixed asset investment ratio as percentage of sales Dell investment needs were $397.8 million.

ii)

iii)

Sources of funds: Dell can manage their funding from two sources: internal and external. Let’s see how much fund, it can generate from internal / operational activities. 

Internal source: From the pro forma statement of funds 1996, we found that Dell can generate $226.48 million cash flow from their operation.



External source: Dell can collect funds from two external sources: Borrowing and equity issue. Dell needs to raise funds $171.32 million2 externally. If Dell maintains the same debt ratio, (14.77% of total asset), debts will be $58.76 million and equity issue will be $339.04 million.

Performance evaluation and recommendations: Based on the numbers provided by Exhibit 4 and 5 of the case, we find that the retained earnings (net profit) come out to be $272 million, and there is no difference in long-term debt. The $272 million in net profit is an increase from the forecasted $227 million and can be attributed to improved net margins from 4.3% to 5.1%. Let’s summarize their performance indicators.

Indicators

1995

1996 Interpretation

Assets Turnover Ratio

2.18

2.46 Efficiency of the firm has increased.

2 External financing required can also be calculated from this formula EFN= (Total assets/sales)*Δ Sales + (Current liabilities/sales) * Δ Sales – Forecasted sales* Net profit margin(1-dividend payout ratio) = (45.87%*1807) - (23.86%*1807) – {5282*4.29%(1-0)} = $171 million

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Dell’s Working Capital Case Solution

Current Liabilities As % of Sales

21.6

17.7 Firm managed to reduce their current liabilities.

Question 3: Assuming Dell sales will grow 50% in 1997, how might the company fund its growth internally? How much would working capital need to be reduced/ or profit margin increased? What steps do you recommend? Several assumptions need to be made to apply the critical approach to prepare Dell’s pro forma balance sheet and pro forma funds flow statement of 1997. 

Sales growth, g = 50%



Cost of sal...