Dell’s Working Capital- Case solution

Case Summary-
Dell Computer Corporation is a company that engages in the manufacturing, sales, and
servicing of personal computers. The company operates on a build-to-order model, whereby
computers are built upon receiving an order from a customer, thereby reducing the amount of
working capital required compared to its competitors.

It also makes it possible for Dell to launch new products more quickly and to take full
advantage of price reductions on components.
Due to its profitability and effective use of working capital, Dell has expanded rapidly and
has been able to finance this growth internally.

Q1. How Dell’s Working Capital Policy a Competitive Advantage?

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.

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 implies 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%)).

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.

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.

Q2. How did Dell fund its 52% growth in 1996?

Dell did some fundamental changes that effectively has direct impact on the growth of Dell
Computer in 1996. Shift towards liquidity, profitability and growth rather than only focusing
on growth. The liquidity and profitability improvement at the same time has funded the 52%
growth in 1996.

Dell had a negative Net profit margin of -1.3% in 1994 because they had to exit the low
margin retail channel segment. In 1995 and 1996 we see a positive net profit margin of 4.3%
and 5.1% respectively because in these years they focused on high margin segments.
Not only net profit margin but also Return on Assets, Return on Total Capital and Return of
Equity has also improved.

The 52.4% sales growth in the year 1996 brought 14.5% ROA, 41.4% ROC and 33.5% ROE.
If we compare these figures with 1995 growth, the improvement is significantly high.

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.
In 1994, Dell adopted the Pentium model processor. The Sales percentage of Pentium based
processor rose two times from the year 1995 to 1996 from 29% to 75%.
For keeping the growth and profit margin stable dell computer hired seasoned managers.
Sales growth could also be impacted of the launch of MS-Windows 95 launch with Dell
Computers.
Q3. Assuming Dell sales will grow 50% in 1997, how might the company fund this
growth internally? How much would be working capital need to be reduced and /or
profit margin increased? What steps do you recommend the company take?
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 sales, operating expenses and financing & other expense will be increased
proportionally with sales growth.
 Net working capital ratio will be same as 1996 (16.9% of sales) and be increased
with
sales growth.
 Other liabilities are considered as a part of working capital.
 Fixed asset investment will be increased proportionately with sales and fixed assets
investment ratio will be 3.61% of total sales.
 Debt ratio will be 10.41% of total assets which will be maintained in 1997.
Considering only long-term debt.
 No dividends will be declared in 1997.

i) Total funds required: Given working capital ratio and fixed asset investment, Dell's
investment needs in 1997 is $543 million’. From the pro forma funds flow statement,
we found that they also need $135 million* of external financing to sustain their 50%
growth. So, their target for sustaining growth is not feasible in this model.

ii) Managing internal sources: If Dell wants to finance the external financing of $135
million internally, they can follow numerous techniques. Such is increasing net profit
margin, increasing payables turnover ratio or decreasing working capital ratio.

 Profit margin increase: If Dell increases their profit margin from 5.14% to 6.14%,
they can achieve $79.44 million.
 Working capital reduction: If Dell reduces their working capital to sales ratio from
16.9% to 15%, they can manage additional $150.94 million.
 Increasing Days Payable Outstanding: Dell could demand immediate payment from
their customers for reducing Days Sale Outstanding (DSO). As they were becoming a
giant in personal computer space, they could demand increased payment terms from
their suppliers that will eventually increase Days Payable Outstanding (DPO). The
combined effort could turn the Cash Conversion Cycle (CCC) negative that will
increase cash in company’s hand, which can be used to fund growth.

iii) Recommendations: Dell can manage financing internally by changing these two ratios.
However, Dell should not finance from one source only. They can use their funds equally
from these two sources or three sources. Relying on only one item such as changing the profit
significantly can damage the market reputation of a high growth company like Dell.
Q4. If Dell repurchased $550 million of common stock and repaid its long-term debt in
1997?
Cash Reserves: The repurchase of stock and repayment of debt would significantly reduce
Dell’s cash reserves, necessitating an even greater focus on working capital efficiency or
profit margin improvements to fund growth.

Equity Reduction: Repurchasing stock reduces equity, which could improve return on equity
metrics but also means less cushion for financing growth.

Debt Repayment: Paying off long-term debt improves the balance sheet and reduces interest
expenses, potentially improving net income.

Cost of Capital: Dell would need to assess its weighted average cost of capital (WACC) post
repurchase and debt repayment. A lower WACC could potentially offset some of the cash
outflows due to these actions.

In both scenarios, Dell would need to rigorously manage cash flows and possibly defer
nonessential expenditures to focus on the most strategic growth opportunities. The key would
be to maintain the delicate balance between aggressive growth, operational efficiency, and
financial stability.

Recommendations:

In recent circumstances, Dell also needs external financing to support their growth. Dell
should
finance their growth and inventory using short-term liabilities. To be more specific,
Dell should do so by extending their payment deferral periods, which can give an interest-
free
sourceoffunding

Also, Dell should adopt an EOQ inventory management system to minimize total
inventory costs, which will reduce the total amount of liabilities Dell needs to sustain their
growthmovingforward.

Conclusion
Dell's working capital analysis was one of the major issues of this case. Dell, as a high
growth company, managed to finance their growth with their operating cash flows. In 1997,
Dell Inc not only repaid their major portion of long-term debt, but they also used to put
option as a source of funds. In recent years, such as in 2014, they managed to reduce their
cash conversion cycle into negative figure. But computer market is always changing. One
company will never be able to grow for lifetime. Dell Inc. faced significant amount of net
loss from 2014 to 2019 fiscal year. From the beginning Dell's strategy was built around a
number of core elements: build-to-order manufacturing, mass customization, partnerships
with suppliers, just-in-time components inventories, direct sales, market segmentation,
customer service, and extensive data and information sharing with both supply partners and
customers. But nowadays Dell and other U.S. personal computers (PC) makers are struggling
to eke out a profit in an environment of falling.