Case #16 Reed Clothiers Essay

1553 words - 7 pages

IntroductionFaced with a loss of financing by his long standing family bank, as well as a 30 day deadline in which he must pay a $130,000 bank note, Jim Reed II, the owner of Reed's Clothier is now facing what he considers to be a monumental financial crisis. Inventory rich, but cash strapped, with only $85,000 in reserves, Jim must now quickly convert a large portion of his $491,000 inventory into cash, in order to meet his pending and future financial obligations.Through the analysis of various financial ratios we will attempt to gain insight into how Jim Reed managed to find himself in his current dire predicament, as well as determine the means by which he might restore his family ...view middle of the document...

The low receivables turnover ratio of 4.9 is an indication of the firm's inability to collect on its accounts receivables.The average collection period of 74.1 days against the industry average of 47.4 days, is a clear indication that Jim is allowing customers too much leniency with credit collection policies. The company's extremely low 7.0 payable turnover ratio (against an industry standard of 15.1) is an equally clear indication that the firm is struggling to repay its debts to its creditors as well.2. Why does Holmes want Reed's to have an inventory reduction sale, andwhat does he think will be accomplished by it?The efficiency ratios for Reed's Clothier indicate that Jim is not effectively managing his working capital. Reed's Clothiers has an abnormally large percentage for cost of goods in common-size comparison to the industry average. The exceptionally large inventory held by Reed's Clothiers can also be seen in Exhibit 2, another common-size comparison that shows that the firm's percentage of inventory is at the unwieldy rate of 30.9 percent to the industry average of 20 percent. This large inventory, although having increased the firm's asset base, does not generate revenue unless it is sold. Having an inventory reduction sale, even at drastically reduced prices, will generate much needed cash. Even if Jim were to sell half of his existing $491,000 inventory at a 25 percent (cash only) sale, he could potentially generate over $184,000 in cash. This would be more than enough to repay his financial obligation to the bank and increase the cash reserve by $54,000.3. 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?In tightening up his working capital to bring it into a better alignment with the industry averages, Jim will be well on the path to restoring his business to financial stability. The end result would be a leaner, more effective and efficient operation. Doing this will not necessarily effect sales. Passing the savings on to his customers in the form of price reductions, sales or discounts will affect sales in a positive way. The most important thing is to meet your customer's demands.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.As can be seen in the pro-forma statement, with depreciation and amortization held steady at $32,000, and with an effective tax rate of 38 percent, a 5 percent reduction in sales would result in corresponding 5 percent decreases in Reed's Clothiers cost of goods, gross profit, general sales and administrative expenses, interest expense, earnings before taxes, and net income. Overall this would be a positive move for the firm,...

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