WORKING CAPITAL: A MODERN APPROACH.

Working capital, defined as current assets (CA) minus current liabilities (CL), is often measured using the current ratio (CA divided by CL), or the quick or "acid test" ratio (CA minus inventory, divided by CL). Good performance was traditionally considered as well in excess of 1:1, with the higher the ratio, the better. The thinking that more is good was driven by lenders' attitudes that working capital constitutes a store of value to pay debts and bank credit lines.

Ratios calculated for various industries for the median and first and third quartiles show the "normal" range of experience. Results outside the interquartile range are considered unacceptable and worthy of corrective action, based on standard ratio analysis from Dun & Bradstreet and the Risk Management Association (RMA, formerly Robert Morris Associates).

The modern attitude is that working capital is undesirable since it constitutes a restraint on financial performance; assets not contributing to return on equity (ROE) are a drag on a business, and may conceal stale, unmarketable inventory and accounts receivables that may not be realized. The focus has evolved to financing CL from continuing activities and carrying only a minimal amount in idle CA, a philosophy that's being effectively implemented by several New Economy companies, including Dell Computer Corp.

Controlling working capital to nearly eliminate CA and CL requires that cash not be expended to prepay for inventory or other operating costs, that vendors hold title to goods until delivery is requested and that redundant expenses be eliminated where possible. Product is sold and a concurrent collection transaction is initiated using a credit card or electronic funds transfer (EFT), thus eliminating most receivables.

Dell manages its operating working capital to attain a zero net time for days' sales inventory minus days' payables outstanding, and has actually reached minus eight days in one quarter! Results include an astonishing inventory turnover of 63.8 times, versus 19.8 times for the computer industry, and an asset turnover of 2.50 versus 1.43.

The impact on Dell's earnings have been dramatic: In the fiscal year ending February 2001, Dell's ROE was 37.2 percent, versus the industry's 30.1 percent. Over the previous five years, Dell's ROE was 63.1 percent; the industry's 32.2 percent. These results came despite lower gross margins (19.6 percent versus 32.9 percent) and lower operating profits (8.1 percent versus 9.7 percent) than the industry averages.

Working Capital Actions

Dell and others have introduced a business model geared to minimum working capital, tight cost controls, low profits per transaction, high sales turnover and fewer owned assets. Managers in these companies focus intensely on core competencies, often removing all but the most critical assets from the balance sheet.

Inventory. In traditional just-in-time, a business owns components and parts, with specified materials required to be in the place of manufacture or assembly at an appropriate time. Dell carries about one-sixth the inventory of the average competitor by requiring vendors to hold title and possession until just prior to computer assembly.

Accounts Payable. Balance sheet percentages show Dell's experience is double that of the industry, and the ratio of the cost of sales-to-payables is 5.9 times, well under the industry average of 9.3 times. Dell holds payables until the dates negotiated with vendors to maximize cash preservation, and claims to have excellent vendor relationships.

Cash. Dell's cash and short-term investments are three times the industry average. In a sense, this underscores Dell's working capital management efforts, which allow the company to respond to changes in the business environment. Industry competitors are currently somewhat cash-squeezed, and have had to more aggressively reduce costs and staffing, defer technology or implement other crisis strategies.

To many companies, current assets are more important than fixed assets. Dell's current assets constitute 70 percent of the company's asset base (sourced at www.dell.com), while the industry norm is 65 percent, according to data from the RMA.

Is it time to re-focus on managing that part of your balance sheets?

James S. Sagner, senior managing principal of treasury consulting firm Sagner Marks.