Reed’s Clothier 1

“Reed’s Clothier” Case Study and Questions

University of Phoenix

FIN/370 – Finance for Business

Amy Grover, MBA

DATE


“Reed’s Clothier” Case Study and Questions

Reed’s Clothier Case Study Analysis

Jim Reed, II the owner of Reed’s Clothier, a men’s clothing establishment is facing financial difficulties. Established in 1934, by Jim Reed to cater to the numerous Virginia Military Institute (VMI) graduates, the business struggled for the first several years. By 1976, the business annual sales had grown to $800,000, where Jim Reed decided to retire and hand over the business to his son, Jim Reed II.

In 1981, Jim decided to expand retail floor space and acquired an $880,000 long-term mortgage debt. During this time, Jim increased inventories with the belief that higher inventories led to higher sales. In 1994, the business had grown to more than $2 million in sales. The increased inventories, along with the acquired mortgage payments have seriously eroded Reed’s positive cash flow.

During the last year, Reed had slowly increased his line of credit at the bank and failed to take advantage of cash discounts offered by suppliers. Now, many of Reed’s accounts are almost 40 days past due, causing suppliers to demand payment. Jim decided to visit his bank in order to further extend his line of credit by an additional $100,000. Harold Holmes of Fist Virginia National Bank has advised Reed that the bank will not extend their line of credit, and that Reed must repay an overdue note of $13,000 within 30 days.

Holmes suggested the Reed seek assistance from a consultant in order to establish a better inventory system and reduce inventories through an inventory reduction sale. Further, Holmes suggested that Reed reduce accounts receivables by aggressively collecting its past-due accounts. Jim was resistant to Holmes’ suggestions, believing that if he was aggressive in collecting accounts, customers may become angry and take their business elsewhere. In addition, Jim continued to believe that higher inventory resulted in higher sales, and that reducing inventory would reduce sales.

After Jim spoke with Holmes, Jim finally realized that the business was in serious financial trouble. Rich in inventory, yet short in cash, Jim Reed must quickly liquidate inventory in order to meet his financial obligations. Through analyzing the various financial ratios, we hope to gain insight into how Reed can restore his family business to a healthy financial position.

Reed’s Clothier Question 1

Calculate a few ratios and compare Reed’s results with industry averages. (Some industry averages are shown in Exhibit 4.) What do these ratios indicate?

Reed's / Industry
Liquidity Ratios
Current ratio / 2.0 / 2.7
Quick ratio / 0.9 / 1.6
Receivables turnover / 4.9 / 7.7
Average collection period / 74.1 / 47.4
Efficiency Ratios
Total asset turnover / 1.3 / 1.9
Inventory turnover / 2.9 / 7.0
Payable turnover / 7.0 / 15.1
Profitability Ratios
Gross profit margin / 29.8 / 33.0
Net profit margin / 4.2 / 7.8
Return on common equity / 16.0 / 25.9

Examining the above ratios, we find that Reed’s is poor in comparison to the industry average on all parameters. Reed’s current and quick ratios are less than the industry average; therefore, establishing Reed’s liquidity is poor. Reed’s low current ratio indicates that the company may have trouble in meeting short-term debt requirements. Further, Reed’s quick ratio is significantly lower than the industry average; a low quick ratio in comparison to current ration indicates a high inventory. Reed’s has excess inventory, and is not selling enough, causing a lower profit margin. Essentially, Reed’s company appears to be in poor financial health.

Reed’s Clothier Question 2

Why does Holmes want Reed’s to have an inventory reduction sale, and what does he think will be accomplished by it?

Holmes wants Reed’s to have an inventory reduction sale in order to restore the relative value of Reed’s quick ration and improve liquidity. In addition, having an inventory reduction sale will generate cash to repay the bank note coming due. Reed’s can generate enough cash to repay the note of $130,000. Short-term cash flows will improve and the carrying cost associated with the acquisition of the excess inventory will be reduced.

Reed’s Clothier Question 3

Jim Reed had adopted a very loose working capital policy with higher current assets than industry averages. If he merely tightens his working capital policy to the averages, should this affect his sales?

Tightening the working capital to align with industry averages will assist in restoring financial stability. This change should have little effect on sales so long as Reed’s does not reduce inventory so slow that he is unable to meet customer needs. Passing savings to customers in the form of price reductions, discounts, and sales will help boost sales.

Reed’s Clothier Question 4

Assuming that Reed’s can improve its operations to be in line with the industry averages, construct a 1995 pro forma income statement. Assume that net sales will be reduced 5 percent to $1,938,000 but that depreciation and amortization will not change but remain at $32,000.

Assuming that Reed’s can improve its operations to be in line with the industry averages, results in the following 1995 pro forma income statement:

1994 / 1995 / Industry
Net Sales / 2,035,000 / 1,938,000
Cost of goods / 1,428,000 / 1,298,460 / 67.0%
Gross profit / 607,000 / 639,540 / 33.0%
General & administrative expenses / 374,000 / 352,716 / 18.2%
Depreciation & amortization / 32,000 / 32,000
Interest expense / 63,000 / 23,256 / 1.2%
Earnings before taxes / 138,000 / 246,126 / 12.7%
Income taxes / 53,000 / 94,962 / 4.9%
Net income / 85,000 / 151,164 / 7.8%

Reed’s Clothier Question 5

What type of inventory control system would you suggest to Jim Reed?

Jim Reed certainly needs to adjust the current inventory control. According to Keown, Martin, Petty, & Scott, 2005, a just-in-time inventory system can reduce inventories, and increase firm value. “…instituting a just-in-time inventory control program can lead to reductions in inventories and, consequently, an increase in the efficiency with which assets are utilized. Other things remaining the same, this could lead to a reduction in expenses and an increase in firm value” (p.458). Obviously, Reed’s would greatly benefit from an inventory system that will reduce inventories and increase efficiency. “The just-in-time inventory control system is more than just an inventory control system; it is a production and management system. Not only is inventory cut down to a minimum, but the time and physical distance between the various production operations are also reduced” (Keown et al., 2005, p. 722).

Reed’s Clothier Question 6

What type of accounts receivable control would you suggest to Jim Reed?

Reed should attempt to place as many customers as possible on COD. “The more that is sold on credit, the higher the proportion of assets that are tied up in accounts receivable” (Keown et al., 2005, p. 707). Of course, not all accounts can be placed on COD; therefore, Reed should use an ageing account schedule. “The aging schedule provides you with a listing of how long your accounts receivable have been outstanding. Once the delinquent accounts have been identified, the firm’s accounts receivable group makes an effort to collect them” (Keown et al., 2005, p. 711). In addition, Reed should specify the terms of sale. “…specify both the time period during which the customer must pay and the terms, such as penalties for late payments or discounts for early payments” (Keown et al., 2005, p. 707).

Reed’s Clothier Question 7

Is the increase in sales related to the increase in inventory? (See Exhibit 5.)

Year / Inventories / Net Sales / Change in Inventory / Change in Sales / Inventory as % of Sales
1991 / 378 / 1,812
1992 / 411 / 1,886 / 8.73% / 4.08% / 21.79%
1993 / 452 / 1,954 / 9.98% / 3.61% / 23.13%
1994 / 491 / 2,035 / 8.63% / 4.15% / 24.13%

There is some correlation between the amount of inventory and the net sales, both having a similar upward trend. This similarity probably perpetuated Jim’s belief that “…sales were lost because an item was not in the store when a customer requested it” (Sulock & Dunkelberg, 1997, p.98). Net sales appear to increase in conjunction with inventory; however, since the change in inventory is much higher than the change in sales, there is no direct link to prove that sales increase as inventory increases. Nevertheless, carrying such a high inventory costs. Carrying high inventory, being lax in collecting accounts receivables, and carrying high debts have led Reed’s into financial ruin.

Part 2: Reed’s Clothier Question 8

What is Reed’s cost of not taking the suppliers’ discounts?

The cost of not taking the suppliers’ discounts can be calculated as follows:

Reed’s cost of not taking suppliers’ discounts is 22.27%, or in terms of dollar amount:

Reed’s purchased 80 percent of its purchases on terms 3/10, net 60; therefore, $1,428,000*80% = $1,142.400. Had Reed’s taken the discount of 3%, Reed’s would have saved $34,272.00.

Individual paper / 10.0 / 10.0
Comment:,nicejob,theratiosarecorrect.Iwouldelaborate
morebysayingin#2raisingcashbyattractingbuyersto
lowprices.In#3,Jimislookingforthecorrectlevelof
networkingcapitalandhowhewillfinanceit.The
reductionshouldnotaffectsales.Inventoryisover50%
higherthanindustryaveragemeanseitherexcessinventory
ortoomuchmoneytiedupininventory.In#5,itis
obviousJimdoesnotknowwhatissellingorwhatisnot.
Youmadeagreatpointaboutacomputerprogramthattracks
inventoryandpoint-of-purchase.Youmentionedjustintimewhichwouldhelp
himtremendously.Youalsomadeagreat
pointaboutaging,tracking,andtighteningcollections(COD).
Inventoryisrisingalmosttwiceasfastassales(lawof
diminishingreturns).In1989,inventoryincreased10%and
8.6%in1990,butsalesincreased3.6%and4.1%
respectively.Jimdoesneedtotakeadvantageoftaking
discounts.Mostvendorswithbacklogswilltreatslow
payingcustomersbynotsendingfullordersorreduced
shipments.Keepupthegoodwork!

Reference

Keown, A. J., Martin, J. D., Petty, J. W., & Scott, D. F. (2005). Financial Management: Principles and Applications (10th ed.). Upper Saddle River, NJ: Pearson Education, Inc.

Sulock, J. M., & Dunkelberg, J. (1997). Cases in financial management (2nd ed.). New York: John Wiley & Sons.