The case examines Reeds Clothiers current working policy as well as suggestions from the

firms banker on how to better manage the firms working capital in order to be able to meet its
obligations as they become due.
1. Calculate a few ratios and compare Reed's results with industry averages. (Some industry
averages are shown in Exhibit 16.4.) What do these ratios indicate?
Exhibit 16.4.
Reed's Clothiers Selected Ratios*
Liquidity Ratios
Industry
Current ratio
2.7
Quick ratio
1.6
Receivables turnover
7.7
Average collection period 47.4
Efficiency Ratios
Total asset turnover
Inventory turnover
Payable turnover

1.9
7.0
15.1

Profitability Ratios
Gross profit margin
33.0
Net profit margin
7.8
Return on common equity 25.9
Liquidity Ratios

Reed

Industry

Current ratio

2.0

2.7

Quick ratio

0.94

1.6

Receivables turnover

4.93

7.7

Average collection period

74.08

47.4

Total asset turnover

1.28

1.9

Inventory turnover

2.91

Payable turnover

6.97

15.1

Efficiency Ratios

Profitability Ratios
Gross profit margin
Net profit margin
Return on common equity

29.8%
4.2%
16.0%

33
7.8
25.9

Examining the attached ratio analysis, it is easy to see that Reed is poor on all the parameters. Its
current and quick ratio is less than industry and so liquidity is poor. It used more assets than the
industry and hence the efficiency in the use of assets is low. It keeps much more inventory and
collects cash more slowly and that possible makes the payables turnover low since it pays after a
longer time to the creditors.
The profitability is also poor with lower gross margin and net margin. The return on equity is
also less than industry average.
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 to have an inventory reduction sale to generate cash. The note is
coming due and there is not enough cash to repay then note. Through an inventory
reduction sale, which can be on cash basis, Reed can generate enough cash to repay the
note. The note is due for $130,000 and the total inventory with Reed is $491,000. With an
inventory reduction sale at reduced prices, enough cash can be generated to repay the note.
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?
There is a possibility that it may affect sales. We look at both the inventories and accounts
receivables
1. Inventory reduction in inventory would imply that at some point in time there
may not be the type of inventory that is needed for sales. The possibility of stock out
increases. Currently there is a high amount of inventory and so there is very little
possibility of stock outs. As the inventory is reduced and if it is not managed
properly, there is a possibility that right inventory is not available at right time and
so a sale is lost.
2. Receivables Currently Reed has a very lose credit polity with average collection
period of 74.1 days as compared to industry average of 47.4 days. As it tightens the
credit policy, there is a possibility that some customers who were buying due to the
higher credit period being given may no longer buy from Reed. Once the credit
period is the same as industry average, the customers may look at all the suppliers
to make a decision.
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.

The income statement is shown below

Reed Clothiers
Income Statement
Sales

1,938,000

Cost of Goods Sold

1,298,460

67.0%

Gross Profit
General and Administrative
Expenses

639,540

33.0%

352,716

18.2%

Depreciation & Amortization

32,000

1.7%

Interest Expense

23,256

1.2%

Earning before taxes

231,568

11.9%

Income Taxes

94,962

4.9%

Net Income

136,606

7.0%

Sales and depreciation and amortization is as given. The rest of the items have the same
percentage of sales as given for industry in Exhibit 1.
5. What type of inventory control system would you suggest to Jim Reed?
Reed should adopt an ABC inventory control system. The inventory should be segregated
based on the value. High value items as A, moderate value as B and low value as C. This
would ensure that more control is exerted over A items then with B or C items. This would
ensure that the value of inventory does not rise excessively as well as obsolescence cost is
lowered since even if C items become obsolete, the value is low and A items are in any case
closely monitored.
6. What type of accounts receivable control would you suggest to Jim Reed?
Jim Reed should control the receivables through the use of Ageing Schedule. An ageing
schedule would report past due in respect to each customer. This would ensure that Reed is
able to follow up with the customers to collect the past due. With an ageing schedule,
relevant information regarding each customer is readily available and so proper targeting
of customers can be done so that effort is put for customers which have the most past dues.
This would ensure that the past due receivables are reduced.
7. Is the increase in sales related to the increase in inventory? (See Exhibit 16.5.)
Year

Net

Change

Change Inventory

1991
1992
1993
1994

Inventories Sales
$378
1,812
411
1,886
452
1,954
491
2,035

in
inventory in sales
8.73%
9.98%
8.63%

4.08%
3.61%
4.15%

as % of
sales
21.79%
23.13%
24.13%

We put the figures in the table above. What the table shows is that the change in
inventory is much higher than the change in sales with inventory increasing as a
percentage of sales. Thus there is no direct link to say that sales increase as
inventory increases. It would be direct if the percentage change was the same. There
could be some correlation, since as more items are kept, there could be a possibility
of higher sales but it cannot be said categorically that increase in sales in related to
increase in inventory.

Exhibit 16.5.
Reed's Clothiers
Year Inventories Net Sales
1991
$378 1,812
1992
411 1,886
1993
452 1,954
1994
491 2,035
8. What is Reed's cost of not taking the suppliers' discounts?
Cost of not taking the discount = (% discount/100-% discount) X 365/(Payment days
discount period)
The terms are 3/10 net 60. The cost is
Cost = 3%/(100-3%) X 365/(60-10) = 22.6%