Dells Working Capital Dr C Bulent Aybar Professor

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 1991 1992 1993 1994 1995 Dell 63% 126% 43% 21% 52% Industry -2% 7% 15% 37% 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 Q 193 Q 293 Q 393 Q 493 Q 194 Q 294 Q 394 Q 494 Q 195 Q 295 Q 395 Q 495 Q 196 Q 296 Q 396 Q 496 DSI 40 44 47 55 55 41 33 33 32 35 35 32 34 36 37 31 DSO DPO CCC 54 46 48 51 55 40 52 51 48 54 53 56 58 56 57 53 43 51 53 45 41 50 42 41 53 45 40 49 44 40 50 46 39 47 44 35 47 42 39 50 43 43 49 43 43 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). Shortterm 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, 296 m an increase of $1, 821 m or 52% from 3, 475 m in 1995. • So if Dell required an increase in operating assets as much as 32% of the increase in sales: – $1. 8 bn x 0. 32 $582 m 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=$335 m • Note that this funding requirement assumes that liabilities remain constant! • If we allowed liabilities change proportionally, Dell would have an excess funding of 139 m. © Dr. C. Bulent Aybar

1995 Balance Sheet as a % of Sales Current Assets: Cash Short Term Investments Accounts Receivables, net Inventories Other Total Current Assets Property, Plant & Equipment, net Other Total Assets Additional Funding Needed Current Liabilities: Accounts Payable Accrued and Other Liabilities Total Current Liabilities Long Term Debt Other Liabilities Total Liabilities Stockholders’ Equity: Preferred Stocka Common Stocka Retained Earnings Other Total Stockholders’ Equity Total Liabilities & Stockholder's Equity Forecast for 1996 with Actual 1996 Sales 29 -Jan-95 % of Sales 43 484 538 293 112 1, 470 117 7 1, 594 1. 24% 13. 93% 15. 48% 8. 43% 3. 22% 42. 30% 3. 37% 0. 20% 45. 87% 403 349 752 113 77 942 11. 60% 10. 04% 21. 64% 3. 25% 2. 22% 27. 11% 403 349 752 113 77 942 614 532 1, 146 172 117 1, 436 120 242 311 (21) 652 3. 45% 6. 96% 8. 95% -0. 60% 18. 76% 120 242 538 -21 879 120 242 538 (21) 879 1, 594 45. 87% 1, 821 2, 315 Fixed Liablilities 66 484 820 447 171 1, 987 178 11 2, 176 355 Proportional Liabilities 66 484 820 447 171 1, 987 178 11 2, 176 (139)

Dell’s Sustainable Growth Rate in 1995 NI(t)/S(t)/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 Current Assets: Cash Accounts Receivables, net Inventories Other Total Current Assets Property, Plant & Equipment, net Other Total Assets Current Liabilities: Accounts Payable Accrued and Other Liabilities Total Current Liabilities Long Term Debt Other Liabilities Total Liabilities Stockholders’ Equity: Preferred Stocka Common Stocka Retained Earnings Other Total Stockholders’ Equity January 28, 1996 January 29, 1995 January 30, 1994 55 726 429 156 1, 366 179 12 1, 557 43 538 293 112 986 117 7 1, 110 3 411 220 80 714 87 5 806 466 473 939 113 123 1, 175 403 349 752 113 77 942 NA NA 538 100 31 669 6 430 570 (33) 382 1, 557 120 242 311 (21) 168 1, 110 NA NA 137 806

Profit & Loss Fiscal Year Sales Cost of Sales Gross Margin Operating Expenses Operating Income Financing & Other Income Taxes Net Profit 1996 $5, 296 4, 229 1, 067 690 377 6 111 272 1995 $3, 475 2, 737 738 489 249 (36) 64 149 1994 $2, 873 2, 440 433 472 (39) 0 (3) (36) 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 1993 $2, 014 1, 565 449 310 139 4 41 102 1992 $890 608 282 215 67 7 23 51

What Happens to SGR if we exclude Short Term Investments NI(t)/S(t)/A(t-1)/E(t-1) 1995 1996 % Retained SGR 4. 3% 4. 31 5. 88 100. 0% 108. 8% 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: Cash Short Term Investments Accounts Receivables, net Inventories Other Total Current Assets Property, Plant & Equipment, net Other Total Assets Current Liabilities: Accounts Payable Accrued and Other Liabilities Total Current Liabilities Long Term Debt Other Liabilities Total Liabilities Stockholders’ Equity: Preferred Stocka Common Stocka Retained Earnings Other Total Stockholders’ Equity 29 -Jan-96 Fixed Liablilities Variance 55 66 (11) 591 484 107 726 820 (94) 429 447 (18) 156 171 (15) 1, 957 1, 987 (30) 179 178 1 12 11 1 2, 148 2, 176 (28) 355 - 466 403 63 473 349 124 939 752 187 113 - 123 77 46 1, 175 942 233 - 6 120 (114) 430 242 188 570 538 32 (33) (21) (12) 973 879 94 2, 148 2, 176 (28) DSO improved by 5 days over the prior year as accounts receivable balance as a percent of sales dropped to 13. 7% from 15. 2%. Inventory levels as a percent of sales also decreased slightly as DSI improved by one day to 31 Overall, assets other than short-term investments fell from 32% of sales in 1995 to 29% of sales in 1996.

1996 Projections vs. Realizations • As a result of improved efficiency Dell reduced current operating assets by $30 m. • 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 Q 4 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 Current Assets: Year Ended 01/28/96 Actual Percent of Sales Cash 55 1% Short Term Investments 591 11% Accounts Receivables, net 726 14% Inventories 429 8% Other 156 3% Total Current Assets 1, 957 37% Property, Plant & Equipment, net 179 3% Other 12 0% Total Assets 2, 148 41% Additional Funding Needed Current Liabilities: Accounts Payable 466 9% Accrued and Other Liabilities 473 9% Total Current Liabilities 939 18% Long Term Debt 113 2% Other Liabilities 123 2% Total Liabilities 1, 175 22% Stockholders’ Equity: Preferred Stocka 6 Common Stocka 430 Retained Earnings 570 Other (33) Total Stockholders’ Equity 973 18% 2, 148 41% Fixed Liabailities Proportional Liabilities Debt Repaid & Repurchase 83 591 1, 089 1, 089 644 234 2, 640 2, 640 269 18 18 2, 927 2, 927 373 (214) 986 466 473 939 113 123 1, 175 699 466 710 473 1, 409 939 170 0 185 123 1, 763 1, 062 1, 378 878 2, 553 3, 141 1, 940 Third column assumes $500 m Stock repurchase and $113 m. Debt 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 Δs • This means that assets should grow by t x Δs 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+ Δs) x (1 -d) • Addition to debt preserving capital structure= New Debt =p x (S+ Δs) x (1 -d) x L © Dr. C. Bulent Aybar

Reorganize to get SGR…. . • T x Δs = p x (S+ Δs) x (1 -d) + p x (S+ Δs) x (1 -d) x L • T x Δs = p x (S+ Δs) x (1 -d) x (1+L) • T x Δs = [p x Δs x (1 -d) x (1+L)]+[p x S x (1 -d) x (1+L)] • T x Δs - [p x Δs x (1 -d) x (1+L)]=[p x S x (1 -d) x (1+L)] • [T - p x Δs x (1 -d) x (1+L)] x Δs =[p x (1 -d) x (1+L)] x S • Solving for Δs/S produces: • 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