Dell’s Working Capital

Financial Management 1
 Dell’s Working Capital
Case Background
Dell Computer Corp, founded in 1984 by Michael Dell, manufactured, sold and
serviced high performance personal computers. The company started off by acquiring IBM’s
personal computers and then selling them, however, they began selling their own brand of
personal computers. Dell took orders from the customers over phone calls and then delivered
the finished product directly to the costumers. This allowed dell to have a strong customer
relationship unlike the other market leaders. This also allowed dell to deliver on customized
user demands in the minimum possible time frame. They were the first ones to provide on-site
servicing so as to differentiate themselves from the competitors.
In 1990 Dell announced broke away from its direct-only business model and began to use
CompUSA as its channel, in an attempt to capture sales from small businesses and first time
consumers. The company also entered the foreign markets, relying on resellers to distribute its
product. Annual sales increased by 268% within 2 years compared to industry growth of 5%
and moved Dell into the top 5 in worldwide market share. Following scrapping of a notebook
computer line, and spending on selling off excess inventory, in 2nd quarter of 1993, Dell
suffered a loss of $75 million dollars. Plus, dell also spent a hefty amount in consolidating the
European market which had become redundant and inefficient.

In 1995, Dell became the first manufacturer to switch its entire manufacturing line to Pentium
technology. Due to its low inventory hold, it was able to readily make the switch, and was
offering the latest technology at the same price at which competitors offered the older
technologies. The company’s growth so far had been financed by its large cash holding,
however, the industry was expected to grow at double digit rate and new plan to finance that
rapid growth was required.
 Key Financial Issues
1.) Funding the 1997 Growth
Dell had recorded a growth of 52% for the year 1996. The growth as we would
analyse in the forthcoming sections was primarily financed internally riding on the
improved asset turnover ratio and stable growth of the sales and corresponding profit.
However, the firm was expected to witness a similar level of growth for the following
year, hence the management needed to figure out ways to finance the same level of
growth.
2.) Increasing Cash Flow Cycle
Dell had a cash flow cycle of 38.5 for the year 1995 which increased to 41.25 for the
year 1996.
If the firm wished to finance its expansion for the year subsequent years it needs to
make sure that its cash flow cycle stays in control. Although dell had a decent level of
free cash flow available to be redirected for expansion purpose, the quicker cash flow
cycle always makes a difference during such aggressive expansion. One of the
reasons for the higher cash flow cycle could be increase in the inventory levels for the
year 1996 which went from 293 Million in 1995 to 429 Million to 1996. Although
dell had a decent record for the inventory management, the steep increase could act as
a hindrance for further expansion. As the inventory is not moving as quickly as it did
before, the cash flow cycle mounted up for the year 1996.
3.) Increasing payables turnover
Looking at the numbers, as we would discuss in further sections, the firm had stable
financial ratios throughout, however, the payables turnover had increased thereby
indicating quicker payouts being done. At the same time, the inventory levels have
increased too. This implies that Dell has been quickly paying out for its purchases but
is not moving the inventory as quickly as it used to, hence increasing the payables
turnover at one hand the CCC at the other.
Looking at the high growth rate that the company is anticipating for the upcoming
years, it would be advisable for the company to pull down the payables turnover at the
same time try and move the inventory quicker.
4.) Asset Turnover Ratio
This functions at the operational level more than the financial level. For the year
1996, one of the key features that financed the huge growth was better utilisation of
the assets. Firm had recorded a growth in asset turnover ratio for the previous years as
it went up from 2.18 in the year 1995 to 2.46 in the year 1996.
The challenge would be maintain the same level of turnover ratio for the upcoming
years. For the year 1997, as we would witness the firm has enough money to finance a
growth in sales in excess of 50%, however, it would require to make sure that the
asset turnover ratio remains at the same level.
5.) Increasing Inventory
The inventory level for the firm increased from 293 Million to $429 Million for the
year 1996. Higher inventory levels gives away the competitive advantage that Dell
had over its competitors. One of the key challenges for Dell would be to maintain the
 inventory levels, thereby giving it the operation flexibility it had in terms product
customisation and adaptation to the latest technology.

Analysis and Interpretations

1.) Dell’s working capital policy
Dell’s working capital policy provided it with a significant competitive edge over
other competitors in the market. Following is an account of the factors the contributed
to this edge:

a.) Build-to-order model: Dell was known to have strong customer relationship. It
took the orders over phone calls and delivered directly to the customers. The
manufacturing began only post the order was received which allowed Dell to
maintain a low inventory levels thereby decreasing its inventory cost. As
compared to its competitors, Dell maintained inventory levels of 10% to 20%
unlike its competitors where the inventory levels varied from 50% to 70%.
b.) Ease of upgrade
When the component cost was reducing, due to technological advancements price
of the components fell by as much as 40%, Dell was able to utilize it to pass on
the savings to customers, by providing them comparative products at cheaper
price. This flexibility apparently stemmed from the fact that Dell maintained
minimal inventory levels.

Further, on launch of Pentium processors in 1994, Dell’s customer connect helped

it anticipate demand for newly developed Pentium based system. Dell over all
these years had developed a strong customer relationship through its on demand
delivery and on-site serving that it offered, something which acted as a major
differentiating factor for Dell as against its competitors. Dell was able to get 75 %
of its sales from product with Pentium models alone by the year 1996. It didn’t
have to dismantle its existing PC’s when a defect was detected for the chips of
Intel, unlike some of the competitors who were shipping the defective pieces to
the customers despite having discovered the defect so as to clear up the large
inventory they were holding on to. The flexibility made it less costly for Dell to
move quickly to capture the market. During Roll out of PC’s with new OS
technology Dell was much faster than competitors. In case of defective products,
it had quicker time to market to replace the products. Dell was also generating
cash by maintaining low cash conversion cycle. More sales could be stimulated on
credit basis. Dell had a low inventory with low fixed assets which help it to
achieve high return on capital employed.
2.) Financial Ratios for the year 1995 and 1996
For 1995:
The current assets stood at $1470 Million while current liabilities were $752 Million.
Also, the net working capital would be 718 Million. Using these figures we obtain the
following:
 Current Ratio = Current Assets / Current Liabilities
CR = 1470 / 752 = 1.95
Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
Quick Ratio = 1.24
Also, the cash conversion cycle = 38.5
Similarly for the year 1996,
We get the following values:
Working Capital = Current Assets – Current Liabilities = 1957 – 939 = $1018 Million
Hence the current ratio is given as: 2.08
While the quick ration = 1.46
Cash Conversion Cycle = 41.25
Now we can analyse the cost that Dell was saving by operating at a lower inventory
level against its competitors by estimating the inventory cost that it would have
incurred had it been operating at the Days’ Supply of Inventory as those of the
competitors.
Against Compaq DSI = (Dell’s COS) (Compaq’s DSI – Dell’s DSI)/360 days =
[($2,737)(73-32)]/360 = $312 million.
Against Apple = (Dell’s COS) (Apple’s DSI – Dell’s DSI)/360 days = [($2,737)(54-
32)]/360 = $168 million.
Additional IBM = (Dell’s COS) (IBM’s DSI – Dell’s DSI)/360 days = [($2,737)(48-
32)]/360 = $121 million.

Inventory Turnover for Dell for the year 1996 and 1995 was 9.86 and 9.34
respectively. Further the receivables turnover as calculated from the exhibit data stood
at 7.29 and 6.46 for the two years. Both the numbers were an improvement over the
previous years. However, the payables turnover ratio increased from 6.79 in 1995 to
9.08 in 1996, hence indicating quicker payout.

As mentioned above, the cash conversion cycle for the company increased, if the firm
wishes to finance its expansion, it would require a higher free cash flow, that would
mean a shorter cash conversion cycle which in one way can be achieved by delaying
the payouts.

3.) 52% Growth for the year 1996

Dell recorded a year to year increase of 52% in terms of revenue. Following is an
analysis of the financials of the company:

Net working capital = Current Assets – Current Liabilities

For the year 1995, working capital = 1470 - 752 = $718 Million
For the year 1996, working capital = 1957 – 939 = $1018 Million
Therefore, net increase in the working capital stood at $380 Million
Further, the increase in sales figures over the previous year could be obtained from
the sales data available in income statement.
 Net increase in Sales in 1996 as compared to 1995 = 5296 – 3475 = $1821 Million

For 1995:
Now the Asset turnover ratio for the year 1995 can be obtained as:
Asset Turnover Ratio = Sales*100/ Total Assets = 3475*100/1594 = 2.18

Short-term investments as percentage of sales = Short investments*100/Sales

= 484*100/3475 = 14%
Current Liabilities as a percentage of sales = 752*100/3475 = 21.6%

For 1996:
Asset turnover ratio = 5296*100/2148 = 2.46
Short-term investments as percentage of sales = Short investments*100/Sales
= 591*100/5296 = 11%
Current Liabilities as a percentage of sales = 939*100/5296 = 17.7%

Apparently, the current assets as a percentage of sales as well as the short term
investments as a percentage of sales fell, however, the asset turnover ratio improved,
hence implying that the firm sourced its growth primarily from better utilisation of its
assets.
4.) Operating Assets for 1996 growth
Dell had its operating assets as a percentage of sales at 32% for the year 1995, while
the short term investments was 14% of the sales. Total assets of the firm was 46% of
the sales.

Now if the sales were to grow by 52% to $5296, then the operating assets would also
require to grow proportionally. Considering the same level of assets utilisation, the
money required to fund the increase in operating assets would be 32% of the increase
in sales figures.
That is, increase in operating assets needed = 32% of (5296 - 3475) = $582 Million

Now, the amount of $582 could be funded from the following sources:
a.) Increase the liabilities, which in this case stood at $494 Million for the year 1996
b.) Profit = 5296 * 4.3% = $227 Million, assuming the same rate of net profit as for
the year 1995
c.) Short Term investments. Dell had $484 Million as short term investments and this
amount could have been utilised to fund the expansion too.

Apparently there was enough resources to fund the expansion internally. As

mentioned in the point 3 above, the firm not just increased the operating assets it also
improved the asset turnover ratio, hence further improving the growth prospects out
of the internal funds.
 Recommendations
As part of the growth strategy for the year 1997, we would adopt the same method to
determine if the growth in excess of 50% could be achieved with internal funds.

Now, operating assets stood at 30% percent of the sales for the year 1996 hence an
increase in 50% for the sales figure would require a proportional increase in the
operating assets assuming similar level of asset turnover ratio.
Net profit for the year 1996 was at 5.1%, we will assume the same figure going in for
the year 1997.
Therefore, the net amount needed to expand the operating assets by 30% would be:
$(2336-1557) = $779 Million
Now, the profit out of the sales assuming same rate as 1996 would be:
5.1% of $5296 x 1.5 = $405 Million
Short term investments for the year 1997, assuming no further investments over 1996
levels would be $591 Million

Therefore, the firm had enough funds to finance the expansion internally, as the
estimated expansion of the operating assets is around $779 Million, lower than the short
term investments and the profit the firm is expected to derive.

Moreover, this could be simplified further if the firm manages to improve the asset
turnover ratio which has been the trend for the last two years.
Exhibit 1

1996 1995

Net Income 272.00 149.00

Shareholder's Equity 973.00 652.00

ROIC/ROE 0.28 0.23

Sales 5296.00 3475.00

Cost of Sales 4229.00 2737.00

Inventory 429.00 293.00

Inventory Turnover 9.86 9.34

Receivables Turnover 7.29 6.46

Payables Turnover 9.08 6.79