Jim Reed, II of Reed's Clothier

Jim Reed, II had meeting with his banker, Harold Holmes of First Virginia National Bank, which is the only bank that Reed's Clothier used since its establishment. The bank informed to him that they can no longer extend their line of credit and demand for the repayment of the over due note payable of $130,000 within 30 days. Holmes suggested Jim to reduce the store's inventory via sale, which is against its traditional semiannual sales in January and July.

Reed's Clothier was founded in 1934 by Jim Reed after he had completed his military tour targeting at Virginia Military Institute (VMI) graduates who lived in and around Lexington, Virginia. Sales were growing each year and that the primary base of ex-VMI graduates was growing. Jim decided to retire and turned the company to his son, Jim Reed II.

In 1976, Reed's occupied the first floor of a three-story building in the heart of downtown Lexington with second floor as the store's office and warehouse and third floor to rent out to the law firm. In 1981, Jim decided to expand the retail floor up to the second floor and created a long-term mortgage debt of $880,000. Jim Reed II had slowly increased the amount of inventory in the store in order to capture all the sales opportunity. As a result, sales had doubled in the last 10 years, but inventory had tripled over the same period.

The increase in purchases and the interest and principal payments on the mortgage had seriously eroded Reed's positive cash flow in the past three years. The cash crunch had been met through a combination of the increase in the line of credit with the bank and not taking the cash discounts from the suppliers. Suppliers term of credit is 3/10, net 60. However, its accounts were now almost 40 days past due, and the suppliers were demanding payment. Otherwise, they will cease the deliveries of the supplies. This causes Jim to think about increasing his line of credit for another $100,000.

However, the banker that Jim normally dealt with, Bob Roberts, had been promoted. Jim has been introduced to Holmes, who had looked to the up to date financial statements of the company. Holmes had noticed the cash flow problems.

Holmes had strongly suggested Jim to reduce his inventories via sales and accounts receivables via aggressively collecting its past-due accounts to the industry averages. Reed's sold about 75% of its sales on terms of net 30, which were the same terms offered by all its major competitors. Jim is afraid that if he aggressively attempted to collect his past-due accounts, the customers will be angry and go to purchase from the competitors.

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?

Liquidity Ratios

Efficiency Ratios

Profitability Ratios

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?