DELLS WORKING CAPITAL

Pre-Read Assignment

ARJUN M K
B17072 | Section-B
Dell Working Capital Arjun M K | B17072

Case Background
Dell, founded in 1984, designs, manufactures, sells and services high performance Personal
Computers (PCs). Originally, the company sold upgraded IBM computers directly to
businesses who ordered via mail. Subsequently, they created their own brand and began to take
orders over toll-free telephone line and shipped directly to customers. Advertising was limited
to computer trade magazines and catalogs.

Apart from the low-cost sales model, Dell had a build-to-order model for its production cycle.
The assembly started after the customer placed an order with the company and the delivery
would be done in a few days. Dell also provided toll-free telephone support and on-site
technical support to improve customer service.

Dells build-to-order manufacturing process helped it maintain a low finished good inventory
and Work in Progress inventory which together accounted for only 10-20% of total inventory
compared to 50-70% for competitors. Dell maintained an inventory of components that formed
80% of cost of a PC. Dell ordered components based on forecasts from its suppliers who
maintained a steady relationship. Many of the suppliers delivered to Dells plants on a daily
basis as they were located close to Dell. In September 1990, Dell broke away from its direct-
only business model to include indirect distribution channel by adding retailers such as
CompUSA, Staples etc. There was an increase of 268% in sales within 2 years and dell moved
to top five ranking in terms of world-wide market share. Dell recorded losses to the tune of $76
million in August 1993 and the firm restructured itself.

Focus was shifted to include liquidity and profitability along with growth and Dell exited from
low margin indirect retail channel. Emphasis was laid on Return on Invested Capital (ROIC)
and Cash Conversion Cycle (CCC) which became companywide metric. Steps were adopted
to improve systems for forecasting, reporting and inventory management. New vendor
certification program helped in reducing the number of suppliers from over 200 to 80 ensuring
component quality, improving delivery performance etc.

Dells re-entry into the notebook market, and rapid introduction of Intels new Microprocessor
chips based on Pentium as it had low inventory of the older 386 and 486 microprocessor helped
it cater to growing customer demand. By 1995, Dell had beome the first manufacturer to
convert entire product line to Pentium technology. The low finished good inventory and
building to order model also ensured that they could replace flawed microprocessors (Intel
Pentium) and update with better model with efficiency which their competitors were not able
to match. Dell was thus able to bring to the customer new technologies in one third of the time
it took for its competitors who used indirect channels.

For the financial year ending 31st January 1996, Dell reported a net income of $ 272 million
over a top-line of $5.3 billion. Even though revenue rose by 52% compared to industry growth
of 31%, results was affected due to component shortages. This would need to be tackled to
improve growth that Michael Dell is targeting.

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Dell Working Capital Arjun M K | B17072

Problems faced by the firm

The PC market is predicted to grow consistently over the years and Dell has to consolidate its
position to maintain and improve its share in the global market without hampering its
profitability. Some of the issues identified from the case are listed below.

Use of indirect channels of distribution

During the initial growth phase of the company, i.e. 1990-93, Dell amended its business
model to include indirect selling along with the direct to customer model. Many mass
market retailers were added and this helped the firm aggressively penetrate the market
especially foreign markets where limitations in infrastructure hampered direct
distribution.

However, the company was required to stock its indirect distribution channels leading
to significant quantity of finished goods inventory. This affected the lean business
model that was the core strength of Dell. The size of inventory would also make it
difficult to implement and introduce new technology models of microprocessors
without incurring huge cost in dismantling and reassembly.

As Dell was internally funded, large finished goods inventory meant that the capital
was tied up and the cash conversion cycle would be higher.

New Vendor certification program resulting in large reduction of suppliers

The case refers to the fact that Dell pruned its suppliers from around 200 or more in
mid 1990s to 80. This must have been the major cause of component shortage faced by
the firm in 1996.

It is to be noted that most of the suppliers are local and situated near to Dells Texas
and Ireland plants. They may have expected long-term relationships and trust and even
cash discounts. Instead, many (possibly competitors) were removed as the suppliers.
Also, the capacity of the retained 80 may not have been sufficient enough to meet the
increased demand in 1996, much less that of the coming years. Also, the heavy
dependence on few suppliers increases their bargaining power for discounts.
Especially, with the stringent quality requirements, they may push for higher margins
for themselves thus increasing the Cost of Goods sold and reducing the Profitability of
Dell.

This can be noted from exhibit 2 where Days Payable Outstanding has reduced from
1993 to 1994 and 95 and recorded its lowest in 4 years for the last quarter of 1996 33
days compared to 44 days for Q4 for the previous year.

Lower importance to cash and cash equivalents

The company was initially fully focussed on growth. In order to capture market share,
a large percentage of its sales would have been made on credit.

The account receivable period hovered around 50 days which resulted in increased
value of cash conversion cycle even as the inventory was maintained at a lower level
almost half of that of competitors such as Compaq computer.

Longer cash conversion cycles meant that the firm needed to carry large amounts of

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Dell Working Capital Arjun M K | B17072

liquid cash and cash equivalents to finance it growth. Cash and short-term investments
accounted for 33% and 30% of the total assets as on financial year ending for 1995 and
1996 respectively. Of this, short-term investment which was in most probability earning
very low interests of 4% after tax was more than 10 times the cash available with the
firms.

An increased cash rotation from the operation should have helped the company move
away from maintaining a significant part of its assets in low-return investment. This is
extremely critical when we note that the return on assets for the company was 9.35%
for 1995 and had improved to 12.66% for 1996 (Total assets considered includes Short
term investment).

If a steady flow of cash from its buyers, be it the direct customers or the indirect sellers
if Dell decides to return to that business model can be ensured, then it is more
meaningful to invest in the business than in short-term investments.

Internal financing of the firm

From the balance sheet of the firm for the year 1995 and 1996, it is observed that the
long-term debt is $ 113 million which has not changed. This debt as a percentage of
total liabilities is only 12% for 1995 and further reduced to 9.62% for 1996. For Dell,
the cost of equity should be considerably higher than the possible cost of debt. Even
though the firm witnessed a loss in Q4 of 1993, there has been considerable recovery
and steady profits over the years. Also, the company has a good reserve of cash and the
general industry PC is expected to grow at a fast pace.

In this scenario, the WACC would considerably reduce if the company resorts to
borrowing for its targeted 52% growth in revenue.

Net Working Capital (NWC) and Cash Conversion Cycle (CCC)

Figures in millions of USD
Year ending
28-Jan-96 29-Jan-95 30-Jan-94
Current Assets (CA) 1957 1470 1048
Current Liabilities (CL) 1175 942 669
NWC = CA - CL 782 528 379
Current Ratio = CA/CL 1.67 1.56 1.57
Total Outside Liabilities (TOL) 1175 942 669
Tangible Networth (TNW) 973 652 471
TOL/TNW 1.21 1.44 1.42

For 1996, Dell had a cost of sales of $ 4229 million with a cash conversion cycle of 46
days. To support their cash needs they should increase their debt as this small amount
of cash may not be able to support their working capital needs. The low cash conversion
cycle based on inventory holding and receivable outstanding works in the favour of the
firm, but Days Payable Outstanding has decreased. To grow at the projected rates, they
require higher Working capital and high amount of liquidity and so must not rely only
on cash but should look for other sources of financing.

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Dell Working Capital Arjun M K | B17072

Analysis and Interpretation

Operational Efficiency
To improve profitability, which is now accepted by Dell as an important metric to measure
performance, it is imperative to reduce the Cost of goods sold by improving operational
efficiency. This can be done by better forecasting techniques for assessing component
requirement from its suppliers. Even though the firm has introduced measures to improve
internal systems for forecasting, reporting and inventory control, the very fact that they faced
component shortage in 1996 causing a hit in revenue shows that operations need to be
improved.

When an order is made two costs are involved one is the handling and delivery cost and other
is cost of storage and the opportunity cost of capital tied up in the inventory. Handling and
delivery charges can be reduced by increasing the order size, however this increases the cost
of storage and the opportunity cost of capital.

So, the firm needs to find a quantity level for components so that the above costs are optimised.
This is the optimal Economic Order Quantity (EOQ) at which the total of handling cost and
the carrying cost is the least.
For instance, if the firm uses components at a constant rate, EOQ is calculated as:

= 2

As Dell needs to continue in the path of expansion and cannot afford to compromise on quality
of the components used, it will have to follow the best component ordering mechanism to
reduce the overall costs associated with the inventory. This will depend heavily on the product
and project management teams and their synergy.

Dells Strengths and Challenges

Dell had a Days Sales of Inventory (DSI) of 32 days, i.e. Dell had inventory to cover 32 days
worth of sales. Low DSI helps to maintain liquidity and a lower level of inventory prevents tie-
up of funds. Competitors following pre-built to supply had to maintain large inventories, with
their DSIs ranging from 48 Days for IBM, to 73 days for Compaq.

Dells Days Sales Outstanding (DSO) averaged to about 50 days. A higher DSO results in a
high cash conversion cycle. Dells Days Payable Outstanding (DPO) decreased from 55 days
to about 33 days hinting at unfavourable credit terms.

Dell always maintained low inventory levels and purchased its raw materials and components
according to orders it received from the customers. Thus, working capital (Cash + Account
Receivables + Inventory Account Payable) provides a competitive advantage to Dell and
contributes to the growth over the industry average. It also helps implementation of new
technological upgrades and keeps them ahead of competition who still had to turnover their
existing inventory.

Dells days supply of inventory (DSI) is 32 days only in 1995 while the DSI average for its
competition (Apple, Compaq and IBM) is 58 days for the same period. This also contributes
to the lower figure for cash conversion cycle.

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Dell Working Capital Arjun M K | B17072

Dell Current Scenario (as at close of FY ending January 1996)

Dell Computer Corporation reported impressive growth for the fiscal year 1996 with its sales
up 52% compared to industry average of 31%. They had earlier financed their growth
internally.
How Dell funded its 52% growth in 1996?
For FY ending January 1995,
=
= 1594 484 = $1110
1110
Operating Assets to Sales Ratio for 1995 = 3475 = 31.94%

In 1995-96, sales increased from $3475 to $5296 in 1996.

Taking operating assets as a proportion of sales, so to figure out the required increase in
operating assets as a percentage of sales: ($5296 $3475) 0.3194 = $582

Dells total liabilities in proportion to sales in 1995 = $942/$3475 = 27.1%

The required increase in liabilities Dell needed in 1996 was:

($5296 $3475) 0.271 = $493.491
Profitability in 1995 = $149/ $3475 = 4.3%
Predicting net income for 1996 = 5296 .043 = $227.73

However, the company achieved net income of $ 272 million in 1996 indicating an
improvement in operational efficiency.

Figures in millions of USD

Year ending
28-Jan-96 29-Jan-95 30-Jan-94
Total asset 2148 1594 1140
Short term investment 591 484 334
Operating Asset 1557 1110 806
Sales 5296 3475 2873
Operating Asset / Sales 29.40 31.94 28.05

Operating Asset ratio decreased by 2.54 percentage points and the difference in value of
operating assets = .0254 5296 = $ 134.5 .

Therefore, one source of funding for its growth in 1995-96 would have been the reduction in
operating assets (disproportionate increase).

Future Scenario (Assumption: Sales Growth of 50%)

Operating assets = ($2148 $591) 1.5 = $2336 .

Increase in the amount from 1996 to 1997 = $2336 $1557 = $779 .
The liabilities and net profit would also increase by 50%.
Net Profit = 1.5 272 = $408 . This is an increase of $136 million.

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34 + 36 + 37 + 31
= = 34.5
4
= 4229 1.5 = $ 6343.7

= = $608
360
= 1.5 726 = $ 1089
= 1.5 466 = $ 699

= + +
= 55 + 1089 + 608 699 = 1053
This is an increase of $271 million from the present level of $ 782 million.
Total increase in liabilities for 1997 = $1175 * 0.5 = $588 million.

We can conclude that dell will have enough funds to fund its operations internally and it can
be done in the following ways:
1) Retained Earnings: Dell could fund the growth by ploughing back of profits and by
liquidating short term investments.
2) Debt: If the cost of debt is not high, external funding should be availed.
3) Reduce accounts receivables and increase account payables so that cash conversion
cycle can be improved further.

Recommendation
The personal computer market is expected to grow steadily over the next few years. Dell
expects to grow faster than the industry, therefore, it needs to adopt a growth strategy that helps
in maximising returns for the funds used.

Therefore, in addition to quality and timely product delivery and service, Dell needs to improve
its Inventory Management, sales forecasting etc.

Build-to-order model worked successfully for the firm, so it needs to maintain the model and
further enhance this model so that it can lead to better results.

Better credit terms need to be availed from suppliers so that the receivables time period is
available for the company to pay its own liabilities. This will also help in improving Cash
Conversion Cycle.