Dell’s Working Capital

Case brief:
Dell Computer Corporation was founded by Michael Dell in 1984. The company designed,
manufactured, marketed, and serviced high-performance personal computers (PCs). Their primary
strategy was to sell to customers directly. Sales were promoted by advertisements in computer trade
periodicals and, later, a catalogue. They began by purchasing IBM computers, improving them, and
selling them directly to customers while taking orders over the phone.
The computers were built after buyers placed orders, a process known as "build-to-order," which
allowed them to keep their finished items to total inventory ratio low. Dell's inventory management-
focused working capital policy was a competitive advantage that enabled them reduce inventory
carrying costs and decrease the risk of obsolescence, as seen by a low completed item to total
inventory ratio.
In fiscal year 1996, Dell Computer Corporation reported a 52 percent growth in revenue over the
previous year. Analysts estimated that the personal computer industry would increase 20% annually
over the following three years, and Michael Dell expected his company's double-digit growth to
continue thanks to its build-to-order manufacturing strategy. Despite the fact that Dell Computer has
previously funded its expansion through organic means, management required a plan for future
growth.

Problem identification:
The following issues should be addressed:
1. To figure out how Dell's working capital approach helped them compete.
2. To figure out how Dell was able to fund its 52 percent expansion in 1996.
3. Create a plan to fund Dell's expansion internally.
4. Due to inventory problems, Dell's full growth potential has been hampered in recent years.
Although their build-to-order inventory method has resulted in a very efficient asset turnover,
this strategy also restricts the company's revenues when customer demand surpasses the
availability of available inventory. Dell must design a strategy for improved inventory
management.
5. To determine how to fund future growth, how much working capital to minimise, and how
much profit margin to improve.

Solution:
Inventory Control at Dell:
After receiving a customer's order, Dell produced computer systems. On the other side, industry
leaders created forecasting and inventory management systems to keep large finished products
inventories in stock or with their channel partners. Dell's build-to-order manufacturing model resulted
in low completed products inventory levels. By the mid-1990s, Dell's work-in-process (WIP) and
finished products inventory as a proportion of total inventory had ranged between 10% and 20%. This
was in stark contrast to industry titans like Compaq, Apple, and IBM, whose WIP and completed
goods inventories generally ranged from 50% to 70% of total inventory, excluding inventory held by
resellers.
Dell has a supply of components on hand. Individual components, such as CPU chips, accounted for
around 80% of a PC's cost. As new technology replaced old, component prices plummeted by an
average of 30% every year. Dell arranged component orders based on sales forecasts. Components
were purchased from about 80 vendors in the mid-1990s, down from a high of 200 or more in the
previous decade. Dell would issue "releases" for a specified number of things from a supplier's
inventory on a regular basis, depending on the forecast. Many suppliers have warehouses near Dell's
Austin, Texas and Ireland operations and supplied parts to Dell on a regular basis.

Dell's Low Inventory Model:

Because little inventory implies low working capital, Dell's low inventory approach will have an
influence on their working capital. Their working capital strategy will reduce the quantity of WIP and
completed goods inventory in their system, lowering inventory financing, storage, and inventory
management costs. Because the suppliers' location is close to the Dell production plants, the suppliers'
daily deliveries to Dell will be just-in-time. Dell maintained their account payable account at a low
volume by waiting until the customer's order came before making the "release" order with their
suppliers.
By waiting until the last minute to order parts, Dell was able to keep both inventory and accounts
payable to a bare minimum. Customers who usually pay with a credit card online or over the phone
were able to make purchases straight from Dell. Dell retained the CCC since they didn't start building
the machine until they got the customer's order (cash conversion cycle to a minimum).
The low inventory strategy will result in low days sales inventory (DSI), which is even lower than the
competitors' DSI:

The COGS for 1995 is $2737 million, according to the balance sheet, so the comparison if 8 Dell's
COGS is the same as competitors' DSI is:

According to the table, Dell would have to raise its 1995 inventory from $243 million to $555 million,
a $312 million increase, in order to compete at Compaq's DSI level. Dell's working capital would
grow as a result of the computations, and the inventory model would no longer be as inexpensive as it
was previously. Dell's inventory is $198 million lower for the same COGS as the industry average
DSI, suggesting a higher working capital requirement. The fundamental reason Dell was able to keep
such a low level of inventory relative to their competitors is because of their competitive strategy of
having a minimal number of inventories.
In addition, when it comes to opportunity loss, Dell outperforms Compaq by a wide margin. It has
been demonstrated that when new technology is adopted, component prices may be reduced by more
than 30%. Compaq's potential loss is 0.3 * $555 million = $166.5 million, compared to Dell's
inventory level of $72.9 million, because it had to sell its current inventory before acquiring new
items.
Dell's idea of working with little inventory and consequently cheap working capital resulted in the
following advantages:
1. There are no items that are no longer in use.
2. Defects in raw material producers were found and corrected rapidly.
3. The number of missed opportunities was minimised.
4. New better technology can be promptly added into the system before the market turns over the
present inventory.
5. In terms of technology breakthroughs, Dell had a leg up on the competition.
6. Due to high inventory turnover and short inventory days, Dell has a low cash conversion cycle.
Dell Funding Climbed by 52% in 1996:
Dell sales increased by 52% to $5296 million in the fiscal year ended January 31, 1996, from $3475
million the previous year. Dell's sales climbed 52 percent year over year, despite the industry's just 31
percent rise. Dell's total asset in 1995 was $1594 million, or 46% of total sales, while its operating
asset was $1110 million, or 32% of total sales.

When sales rise by 52%, the operational assets must rise by the same percentage. As a result, the
operational assets for 1996 must be:
Operating Asset = $5296 million multiplied by 32 percent = $1695 million in 1996.
In 1996, the operational asset was $585 million more than it was in 1995. In order to meet the 52
percent growth objective established in 1996, Dell will need to locate an extra source of money to
offset the expenditure in this operational asset.
By looking to internally source of funds, it can be seen that the liabilities less accounts payable have
increased from 1995 to 1996 as much as $494m:
1996 liabilities less account payable – 1995 liabilities less account payable $(2148-466) m - $(1594-
403) m = $494m
Also, the profit margin for 1995 is 4.3% (149/3475 * 100), assume the profit margin for 1996 stay the
same, then the projected operational profit for 1996 is $227m
1996 projected net profit = $5296m * 4.3% = $228m, resulting in a total cash inflow of $722 million
($494 million + $228 million). Because the total cash inflow is greater than the required additional
operating asset, the company can fund itself through internal sources.
It can be shown as follows when looking at their asset turnover ratio, short term investment ratio, and
current liabilities ratio to sales:

1995 1996
Asset Turnover Ratio 3475/1594 = 2.18 5296/2148 = 2.46
(Sales/Total Asset)
Short-term Investment as % of 484/3475 = 14% 591/5296 = 11%
sales (Short investment/Sales)
Current Liabilities as % of 752/3475 = 21.6% 939/5296 = 17.7%
Sales (Current liabilities/Sales)

Those indicators reveal how Dell supported its 52 percent growth in sales: first, the asset turnover
ratio has risen from 2.18 to 2.46, suggesting that the company's asset efficiency has improved. Dell
was able to fund its 52 percent rise over the previous year by lowering the percentages of short-term
assets and current commitments. In conclusion, Dell financed sales growth by raising current
liabilities and improving their asset turnover ratio, which suggests they made better use of their assets.
In 1997, how did Dell fund its sales growth?
Based on fixed commitments vs proportional liabilities, it was expected that Dell sales in 1997 would
rise by 50% to $7944 million from $5296 million in 1996. Also, whether or not to include or exclude
share repurchases and long-term debt payments. Dell's overall asset was $2148 million in 1996,
accounting for 41% of sales, while its operating asset was $1557 million (2148-591), accounting for
29.4% of total sales.

Then, in 1997, when sales grow by 50%, the operating assets must also expand by 50%. As a result,
the functioning assets in 1997 must be:
Operating Asset = $7944 million multiplied by 29.4% = $2336 million in 1997.
The operating asset in 1997 is $779 million more than the operating asset in 1996. To reach the
expected 50 percent increase in 1997, Dell will need to acquire extra source funds to satisfy the
expense in this operating asset.
When it comes to internal sources of cash, the 1996 liabilities less accounts payable margin to sales is
31.7 percent (($2148m - $466m) / 5296). If the liabilities minus account payable margin stays the
same in 1997, the obligations less account payable for 1997 will be $2518 million (31.7 percent *
7944). The liabilities, less accounts payable, grew by $836 million between 1996 and 1997:
Liabilities minus accounts payable in 1997 – liabilities minus accounts payable in 1996 $836 million
= $2518 million – $(2148-466) million.
In addition, the profit margin for 1996 was 5.1 percent (272/5296* 100). Assuming that the profit
margin for 1997 remains the same, the estimated operational profit for 1997 is $405 million (5.1
percent * $7944 million).
Dell's overall cash inflow for 1997 is $1241 million ($836 million + $405 million) since the total cash
inflow exceeds the needed extra operational asset. In 1997, the corporation may support sales
expansion from internal sources since total cash inflow exceeds the needed extra operational asset.
Dell has improved working capital management to cut costs and increase efficiency, as well as profit
margins. Dell now has four advantages as a result of these enhancements:
1. Invest in your future.
2. Assist with debt payback
3. Stock repurchases
4. Use internal money to finance expansion.
Savings from Working Capital improvement:
  DSI DSO DPO CCC
Q496 Actual 31 42 33 40
Hypothetical Improvement -15.5 -14 16.5 -46
1997 Projected 15.5 28 49.5 -6
         
Hypothetical Improvements 15.5 14 16.5  
Daily savings (Sales/COGS) ($
millions) 17.4 21.8 17.4  
Annual Savings 269 305 287  
Total 861      

Improving the cash conversion cycle in order to boost financing

If debt is serviced and stocks are repurchased, the investment need increases by $500 million to $1091
million. Currently, the following awards are available: A short-term investment of $591 million.
Increase the profit margin by 2% to produce an extra $159 million (0.2*$7944 million) in money. The
remaining shortfall amounts to $432 million. These funds can be obtained by altering the cash
conversion cycle. There are three ways to alter the cash conversion cycle:
a) Inventory decrease based on age
b) Shortening the time taken to collect accounts receivable
a) Extending the accounts payable payment term
Reducing the age of inventory
Inventory accounted for 8.1 percent of sales in 1996, with $429 million in stock. Inventory will be
$644 million in 1997 if inventory as a proportion of sales remains unchanged. In order to obtain $432
million in additional money, Dell must reduce the value of its inventory. The 1997 DSI is 37 days if
the COGS in 1997 are pro forma to the COGS as a percentage of sales in 1996 ($6344m). To get an
additional $432 million, the DSI must be lowered; the COGS per day is 17 (COGS/365=6344/365);
the NBP/COGS per day is 25 ($432m/17); and the DSI must be reduced to earn an additional $432
million.
Reducing the time taken to collect account receivables:
If the account receivable percentage of sales is the same in 1996 and 1997 (13.7%), the account
receivable in 1997 is $1089 million. In 1997, the collection period was 50 days (AR/sales per
day=$1089m/$22m), but it had to be cut in half to get an extra $432 million. The collection time for
the new 1997 collecting period, which is to be 30 days, must be lowered by 20 days if the NBP/sales
per day is 20.
Increasing account payable payment period:
Assume that in 1996 and 1997, the account payable share of sales remains at 8.8%. In 1997, the
account payable amounted $699 million. In 1997, the payment term was 41 days (AP/COGS per
day=$699m/$17m), but it needed to be cut in half to get an extra $432 million. If the NBP/COGS per
day is 20, the new 1997 collecting period, which would be 66 days, will need to be extended by 25
days. If Dell changes its cash conversion cycle in one of those three ways, it will be able to raise an
extra $432 million to support the buyback of its $500 million common shares.
Projected P&L for the year 1997:

Fiscal Year 1996 1997 Projected

Sales $5,296 7944
Cost of Sales 4,229 6344
Gross Margin 1,067 1601
Operating Expenses 690 1035
Operating Income 377 566
Financing & Other Income 6 9
Income Taxes 111 167
Extraordinary losses    
Net Profit 272 408

Forecasted Balance Sheet for the year 1997:

Forecasted Balance Sheet of Dell Computers for year 1997 (millions of dollars).
       
  1996 Actual    
  January 28, Percent   Proportional
  1996 of Sales   Liabilities
Current Assets:        
Cash 55 1.0%   83
Short Term Investments 591 11.2%   752
Accounts Receivables, net 726 13.7%   1089
Inventories 429 8.1%   644
Other 156 2.9%   234
Total Current Assets 1,957 37.0%   2801
Property, Plant & Equipment, net 179 3.4%   269
Other 12 0.2%   18
Total Assets 2,148 40.6%   3088
Total Current Liabilities 939 17.7%   1409
Long Term Debt 113 2.1%   113
Other Liabilities 123 2.3%   185
Total Liabilities 1,175 22.2%   1706
Stockholders’ Equity:        
Preferred Stock a
6 0.1%   6
Common Stock a
430 8.1%   430
Retained Earnings 570 10.8%   978
Other (33) -0.6%   -33
Total Stockholders’ Equity 973 18.4%   1381
Total Stockholders’ Equity+Liabilities 2,148 40.6%   3087
Additional Funding Needed       1
      408