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Case 16: Reed's Clothier, Inc.: Working Capital Policy

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Questions
 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 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 = sales/accounts receivable Average collection period = 365/receivable turnover Total asset turnover = cost of sales/total assets Inventory turnover = cost of sales/inventories Payable turnover = cost of sales/accounts payable
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 16.5.)
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?

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This solution is comprised of a detailed explanation to calculate a few ratios and compare Reed's results with industry averages.

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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

The liquidity ratios are the ratios that are used to measure the company's ability to pay off short-term debt when they come due. For current ratio and quick ratio, it should be at least greater than 1. For receivable turnover, it will be good for the company if the turnover is high, which will indicate the effective collection from the customers. The average collection period for the firm with high receivable turnover will be short.

By comparing Reed's results with industry averages, we can see that Reed is far behind than the industry averages, having problems to meet short-term obligations and weak past due collections policy.
Industry

Current ratio = Current Assets/Current Liabilities
= 921/457 = 2.02 2.7

Quick ratio = (Current Assets - Inventory)/Current Liabilities
= (921 - 491)/457 = 0.94 1.6

Receivable turnover = Sales/Accounts receivable
= 2,035/413 = 4.93 7.7

Average collection period = 365/ Receivable turnover
= 365/4.93 = 74.08 47.4

Efficiency Ratios

The efficiency ratios are the ratios that are used to measure the efficiency of the company to manage its assets, inventory, and payment. The high total asset turnover and inventory turnover will indicate high efficiency rate for the company. For payable turnover, it will ...

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