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# Inventory Ratio and Working Capital

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Business Depot consistently sells \$20,000,000 (Cost of Goods Sold) in office supplies each year. Their inventory turnover ratio has be 2 for the past few years. A new CFO with extensive industry experience has recommended a new Inventory Control System that promises to increase the inventory turnover ratio to 4 at the same level of sales. How much working capital will be freed up?

#### Solution Preview

Inventory ratio = cost of goods sold/inventory

Cos of goods sold = ...

#### Solution Summary

This solution calculates the initial and final inventory ratio to estimate the change in working capital.

\$2.19

## Reed's Clothier: Ratio Analysis and Working Capital Management

See the attached document and answer the eight questions found on the bottom. For question 1, calculate all of the ratios listed in Exhibit 4 of the case.

Jim Reed, II had just left a rather unpleasant meeting with his banker, Harold Holmes of First Virginia National Bank. Jim had banked with First Virginia for almost 30 years and his father, who had established Reed's Clothier in 1934, had only banked with First Virginia. Holmes, however, had just informed Jim that the bank would not extend their line of credit any further. In addition, the over due note payable for \$130,000 must be paid within 30 days. Jim could not believe that Holmes had the temerity to tell him he needed to drastically reduce the store's inventory and to strongly suggest an inventory reduction sale. Since its founding, Reed has only held the industry's traditional semiannual sales? in January and July. Although Jim was piqued by this young banker's demand, the note was over 45 days past due, and Jim did not know how he could make any more than a token payment on the note within the next 30 days.

BACKGROUND

In 1976, Reed's occupied the first floor of a three-story building in the heart of downtown Lexington. Reed's used the second floor of the building as the store's office and as a warehouse. The third floor, with an outside entrance and elevator access, was rented to the law firm of Bundy, Hawk, and Harrington. In 1981, Jim decided to expand the retail floor space by refurbishing the second floor as a retail shop and using the third floor as a warehouse and office. The first floor was then also modernized and the store had a very contemporary look and an \$880,00 long-term mortgage debt. Jim Reed II had slowly increased the amount of inventory in the store with the belief that many sales were lost because an item was not in the store when a customer requested it. Sales did grow steadily each year, topping \$2 million in 1994, which bolstered Jim's belief that the increase in sales was directly related to the increase in inventory. In fact, sales had doubled in the last 10 years,but inventory had tripled over that same period of time.

CURRENT SITUATION

The increase in purchases and the interest and principal payments on the mortgagehad seriously eroded Reed's positive cash flow in the past three years. Thecash crunch had been met through a combination of slowly increasing the lineof credit at the bank and, during the last year, not taking the cash discountsoffered by the store's suppliers. Reed's purchased about 80 percent of its purchaseson terms of 3/10, net 60 and until this year had always taken the cash discount, but its accounts were now almost 40 days past due, and the supplierswere demanding payment with the threat of ceasing deliveries until paymentwas made. This threat had pushed Jim into going to see his banker with the idea of increasing his line of credit another \$100,000.

QUESTIONS
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?

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

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?

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.

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

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

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

8. What is Reed's cost of not taking the suppliers' discounts?

PART IV WORKING CAPITAL MANAGEMENT
EXHIBIT 1
Reed's Clothiers Income Statement (in 000s)
Common Size
Reed's Industry
Net Sales \$2,035 100% 100%
Cost of goods 1,428 70.2 67.0
Gross profit \$607 29.8 33.0
General & administrative expenses 374 18.4 18.2
Depreciation & amortization 32 1.6 0.9
Interest expense 63 3.1 1.2
Earnings before taxes 138 6.7 12.7
Income Taxes 53 2.6 4.9
Net income \$85 4.1% 7.8%

EXHIBIT 2
Reed's Clothiers Balance Sheet (in 000s)
Common Size
Reed's Industry
Cash \$17 1.0% 1.5%
Inventories 491 30.9 20.0
Accounts receivable 413 26.0 20.1
Total current assets \$921 57.9 41.6
Fixed assets 670 42.1 58.4
Total assets \$1,591 100.0% 100.0%
Accounts payable \$205 12.9% 9.3%
Notes payable 234 14.7 6.4
Other current liabilities 18 1.1 0.2
Total current liabilities \$457 28.7 15.9
Long-term debt 604 38.0 30.4
Total liabilities \$1,061 66.7 46.3
Stockholders' equity 530 33.3 53.7
Total liabilities and stockholders' equity \$1,591 100.0% 100.0%
CASE 16 REED'S CLOTHIER, INC.

EXHIBIT 3
Reed's Clothiers Aging Schedule
Days Past Due Amount Percent
(000s)
0-29 132 32.0
30-59 90 21.8
60-89 89 21.5
Over 90 102 24.7
\$413 100.0

EXHIBIT 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 1.9
Inventory turnover 7.0
Payable turnover 15.1
Profitability Ratios
Gross profit margin 33.0
Net profit margin 7.8
Return on common equity 25.9
*Since many ratios may have different meanings the following definitions were used in the above calculations:
Receivable turnover 5 sales/accounts receivable
Average collection period 5 365/receivable turnover
Total asset turnover 5 cost of sales/total assets
Inventory turnover 5 cost of sales/inventories
Payable turnover 5 cost of sales/ accounts payable

EXHIBIT 5
Reed's Clothiers
Year Inventories Net Sales
1991 \$378 1,812
1992 411 1,886
1993 452 1,954
1994 491 2,035

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