Case Summary
The essence of the case lies in the fact that Jim Reed II, the owner of the Reed’s Clothier stores, faces the issue of not obtaining the extension of the credit line for $100,000 from First Virginia National Bank with which the company has worked for decades. The point is that the former banker of Reed’s, Bob Roberts, was replaced by the young Holmes who refused to extend the credit line and advised Reed to sell the inventory of the company.
Answers
Current ratio of Reed’s equals the relation of current assets to current liabilities, i. e. 2.0, quick ratio = cash + accounts receivable/current liabilities = 1.0 + 26.0/28.7 = 0.9. Reed’s receivable turnover = sales/accounts receivable = 100/26 = 3.8, while the average collection period = 365/receivables turnover = 365/3.8 = 96.0. Total assets turnover = cost of sales/total assets = 70.2/100 = 0.7, inventory turnover = cost of sales/inventories = 70.2/30.9 = 2.3, payable turnover = cost of sales/accounts payable = 70.2/12.9 = 5.4. Gross profit margin = gross profit/total revenue = 29.8/6.7 = 4.4, net profit margin = net income after taxes/total revenue = 4.1/6.7 = 0.6, return on common equity = net income/stockholders’ equity = 4.1/33.3 = 0.1.
The comparison of the ratios calculated for the industry and for Reed’s shows that the latter experience problems especially with receivables turnover, average collection period, inventory turnover, payable turnover, gross profit margin, net profit margin, return on common equity. The inventory reduction sale offered by Holmes will help improve the inventory turnover and payable turnover as the amount of inventory will decrease substantially and the sales rate only for not more than 0.5% annually.
The policy of current assets of Reed’s being higher than the industry averages is rather dangerous, and the reduction of assets to the industry levels will not affect the sales as they increase twice while inventories and assets increase three times becoming excessive. Accordingly, if we assume that the assets are reduced to the averages the 1995 pro forma income statement of Reed’s will look as follows:
To solve the inventory issues, the more modern and multifunctional inventory control system that includes the options of warehousing, e-commerce, customer management systems, sales tracking, and product data management besides the very inventory control function can be recommended. The examples include software packages like Warehouse, SkuFlow, etc. In accounts receivables control, the combination of confirmed receivable balances and required approval of credits can be recommended.
The increase in sales is hardly related to inventory increase as the latter grew by 28,9% between 1991 – 1994, while sales grew only by 12,3%. Therefore, inventory increase is the waste of funds not related to sales growth. Finally, if Reed stops taking suppliers’ discounts, it will cost him 40% of the supplied goods value as formerly he bought goods net 60, meaning that Reed paid for 60% of their value.