“Dell designs, develops, manufactures, markets, sells, and supports a range of computer systems and services that are customized to individual customer requirements” (“Business Summary,” 2009). Customers can purchase Dell desktop computers, laptops, servers, printers, and software from the Dell Web site or speak with a sales representative on the telephone. The various customers of Dell include various U.S. government agencies, healthcare, corporate, and education entities. Dell uses financial statements and other data to communicate its financial position with investors and other users of financial information.
Understanding Annual Reports
Investment capital is always moving between different markets, industries, and nations. “The goal of accounting information is to provide economic decision makers with useful information,” according to Williams, Haka, Bettner, and Carcello (2006, p. 670). Users of financial statements determine market and financial trends within a company and in the external business environment through the use of financial statements. Different users use financial statements differently and address different needs, such as data providing investors on whether they should buy or sell certain companies’ stocks. In the examination of Dell annual reports for 2005 and 2005, the researcher needs to use general tools of analysis, such as ratios, financial leverage, examine the cost of capital and other financial incentives for the company.
Companies use calculations between different sets of data on the annual report to determine the short-term financial health and long-term financial health of the firm. Ratios also provide the changes in a company caused by internal and external factors often not displayed in individual financial statement information, such as the cost of goods sold. “A ratio is a simple mathematical expression of the relationship of one item to another,” according to Williams, Haka, Bettner, and Carcello (2005, p. 674). Different ratios provide different information to different financial information users, including the company.
“Investors commonly use the current ratio to evaluate a company’s liquidity” (Kieso, Weygandt, and Warfield, 2007, p. 386). A company is better able to meet its current payments and other obligations as they come due if the current ratio is higher. The formula for calculating the current ratio is The current ratio for Dell in 2005 was 1.11:1 while the 2006 current ratio was 1.12:1. The 2005 ratio of 1.11:1 means that for every dollar of current liabilities, Dell has $1.11 of current assets. Dell current ratio increased in 2006 and is lower than the industry average of 2.2, meaning Dell might be encountering difficulty in making payments as these payments become current.
Acid-test (Quick) Ratio
The quick ratio (acid-test ratio) provides a view of the company’s short-term liquidity and is calculated by the following equation: . The quick ratio complements the current ratio because the quick ratio examines components of short-term liquidity not examined by the quick ratio; also, the inventory displayed on the balance sheet may not be available for current sale. The quick ratio for 2005 was 0.78:1 and increased in 2006 to 0.88:1. Given that the industry average is 2.1:1, Dell’s quick ratios seem a little low, as the company may have slow-moving merchandise (such as computers) or inventories that have become excessive in size” (Williams, Haka, Bettner, and Carcello, 2005, p. 674).
Inventory Turnover Ratio
Inventory turnover is “the number of times on average the inventory is sold during the period” (Weygandt, Kieso, and Kimmel, 2005, p. 697). This ratio measures the liquidity of the inventory and is calculated by the equation cost of goods sold/average inventory = inventory turnover. Dell inventory turnover ratio declined from 106.29 in 2005 to 93.17 in 2006, thereby identifying less cash tied up in inventory and decreased chance of inventory obsolescence. The industry average in the Personal Computer Systems industry is 49.1, so Dell’s inventory turnover rate is above average.
“If a business fails and must be liquidated, the claims of creditors take priority over those of the owners, according to Williams, Haka, Bettner, and Carcello (2005, p. 679). A company being liquidate might not have enough capital to satisfy all outstanding debt and the claims by the owners, thus the need for the debt ratio in protecting creditors’ claims on firm assets. The ratio is found by dividing total liabilities by total assets. In examining this ratio, Dell had a debt ratio of 0.83 for 2006, which is higher than the 2005 debt ratio at 0.82. Both ratios are respectable because the company still displays it has more assets than debt and this can be attractive for potential investors and lenders, thus providing increased leverage against its competitors. If the debt ratio were closer to 1 or over 1 a company might be struggling in satisfying debt repayments, thus hurting the company’s chances of attracting future capital.
Net Profit Margin Ratio
“The profit margin tells you how much profit a company makes for every $1 it generates in revenue” (Kennon, 2009). The net profit margin, also known as Return on Sales, evaluates the company’s operational efficiency. Most companies agree the higher the profit margin against their competitors, the better for said companies. Calculating Return on Sales involves dividing net income, after taxes, from sales and the equation is: net income/sales = ROS. In examining the annual reports for Dell and taking the values necessary for 2005 and 2006, the ROS for 2005 is 6.4 percent and the ROS for 2006 is 4.5 percent. Thus the profits for Dell have decreased 1.9 percent in the past year and the results are much lower than the industry average of 12.3 percent.
Return on Investment
Investors want an assurance that the company in which they invest will efficiently manage their financial resources. One method of determining such efficiency is with the use of the return on investment ratio (ROI), also known as the return on assets ratio (ROA). The formula used is: . Using the data from the annual report, Dell had a ROI of 15.17 percent in 2005 and 10.63 in 2006. The percentage for 2005 was higher than the historical industry average of 13.8 percent (MSN Money, 2009) and, even though the average for 2006 was lower, the higher percentage means investors will be attracted to Dell as an investment opportunity.
Return on Equity
Return on Equity is a profitability ratio that defines the amount of profit a company generates from shareholder investments. The formula for ROE is: net income/shareholders’ equity. Using this formula on the annual reports from Dell, the company’s ROE is 66.22 percent in 2005 and 61.25 percent in 2006. The ROE for Dell is higher than the industry average of 31.8 percent, meaning the company is managing its equity better than other competitors in the personal computer systems industry.
Price-to-Earnings Ratio (P/E Ratio)
The price-earnings ratio is “the relationship between the market price of common stock and earnings per share” according to Williams, Haka, Bettner, and Carcello (2005, p. 688). The P/E ratio decreased from 24.3:1 in 2005 to 22.2:1 in 2006, meaning the company is experiencing issues with the earnings per share and also lower stock prices. The industry average for the P/E ratio is 14.1 and this indicates that Dell is higher than the industry average for the personal computer systems industry.
Working Capital Management
In examining the previous ratios, the information came from either the balance sheet or the income statement; however, the cash-flow statement should be examined to provide an overall picture of health for a company. Cash from operating activities, cash from investing activities, and cash from financing activities are the three sections that comprise the cash-flow statement. Debt can be paid down internally if the balance of the operations section is positive and the other two sections display negative balances.
Starting with net income and the items that cause a difference between income and cash flow, states Tergesen (2001, p. 2). In 2005, Dell reported cash from operating activities of $4,751 million (Dell, 2006) and reported $3,969 million in 2006.
Dell is not optimizing its accounts payable because the amount increased from $9,868 million in 2005 to $10,430 million in 2006. Inventories on the cash-flow statement align with the inventory turnover ratio because the company reduced the ratio in 2006, thereby controlling its inventory levels with fast turnaround of inventory.
In examining the cash-flow statement, Dell is optimizing its cash cycle because the financing section has a negative balance, with the company lowering the amount in 2006. Dell is moving toward controlling financing and investment activities but the company needs to ensure more investors or potentially buying back stock to ensure a balance between the amount of cash going to payment of debt and the amount of cash paid to the company.
Debt and Equity: Finding the Right Balance
Dell uses a combination of debt and equity to finance current operations and long-term projects. The debt is comprised of $200 million senior convertible notes (bonds) with an interest-bearing rate of 6.55 percent of the issue price, paid semiannually, with $1,000 face value paid on maturity; in addition, the company issues $300 million fixed rate (10 percent) senior debentures with the principal balance due April 15, 2028. The notes are convertible into common stock at the discretion of the holder of the note. Such debt allows the company to fund various projects and operations.
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Equity differs from debt because shareholders provide the capital to the company in exchange for financial instruments, usually common stock. Dell issued 7 billion shares of common stock, with $.01 par value per share, and 785,000 shares of Treasury stock with $1000 face value. The current amount of capital received in the sale of stocks was $9.503 billion in 2005 and $10.107 billion in 2006, as issued shares of stock were 3.307 billion in 2006 and 2.818 billion in 2005, while outstanding shares (unpurchased) were 2.226 billion in 2006 and 2.330 billion in 2005; this means Dell might be buying back shares of its stock.
Weighted-Average Cost of Capital
The weighted average cost of capital, also known as WACC, involves a “calculation of a firm’s cost of capital in which each category of capital is proportionately weighted” (Investopedia, 2009). Every type of financial instrument used to finance and fund operations and projects is included in the WACC and includes (a) common stock, (b) preferred stock, and (c) debt. The equation for WACC involves the cost of each component, multiplied by its weight, and then adding the sum of both debt and equity:
In estimating the WACC, a company looks to optimize its current capital structure. In the case of Dell, the following figures represent the current cost of capital, given the capital structure for the company:
Weighted average cost of capital
Entering in the totals for 2005 and 2006, with respect to total debt and total equity, Dell has a weighted average cost of capital at 11.5 percent in 2005 and a weighted average cost of capital of 12.0 percent in 2006. Given that the table displayed a WACC of 8.42 percent, the company is depending on the buyback of stock to increase its WACC; in addition, too much debt may provide difficulties for Dell if the company utilizes too much debt to finance operations and long-term projects.
Examining the different items on the financial statements by using ratio analysis and WACC allows the researcher to understand Dell’s financial structure and whether investment in the company is properly balancing its debt and equity mix. Given the various ratios, Dell is meeting or exceeding industry standards. The company should look to reduce its cost of equity and increase its cost of debt to provide the company with a better overall capital cost structure. Even with the buyback of its shares, Dell should increase the amount of debt to increase financial leverage.
In viewing the ratio data, Dell remains a good buy; however, the current economic downturn may change the attractive quality of the stock as investors continue their nervous trend of selling stocks. One point for investors to watch is the financing from operating activities, as Dell does not have to report its operating leases on any financial statements; this could possibly give an inflated view of operations and offset any new revenue generated by the company. The current economic environment and the increase in debt financing caused a decrease in the valuation of the stock but Dell is handling its sales and financing according to current market trends, thus causing a recommendation in purchasing stock in Dell. Shareholders were advised to hold their shares of Dell stocks, meaning the market is responsive to Dell as a company.
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