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# Ratio Analysis to solve Reed's Clothiers Cash Flow Problem

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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 tumover = cost of sales/total assets Inventory turnover = cost of sales/inventories Payable turnover = cost of sales/accounts payable.

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

C.) 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?

D.) 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.

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

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

G.) 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

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

#### Solution Preview

For your convenience, I have attached a formatted MS Word file containing the information below.

Faced with a loss of continued financing by his long standing family bank, as well as a 30 day deadline in which he must pay a \$130,000 bank note, Jim Reed II, the owner of Reed's Clothier, a respected and well known men's clothing establishment, is now facing what he considers to be a monumental financial crisis. Inventory rich, but cash strapped, with only \$85,000 in reserves, Jim must now quickly convert a large portion of his \$491,000 inventory into cash, in order to meet his pending and future financial obligations.

Through the analysis of various financial ratios we will attempt to gain insight into how Jim Reed managed to find himself in his current dire predicament, as well as determine the means by which he might restore his family business to full financial health.

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?
Financial ratios are a valuable and easy way to interpret the numbers found in statements. It can help to answer critical questions such as whether the business is carrying excess debt or inventory, whether customers are paying according to terms, whether the operating expenses are too high and whether the company assets are being used properly to generate income.

When computing financial relationships, a good indication of the company's financial strengths and weaknesses becomes clear. Examining these ratios over time provides some insight as to how effectively the business is being operated.
In comparing the financial ratios of Reed's Clothiers to the averages of others in the same industry, it readily becomes clear that Jim's preference of keeping a large inventory of clothing on hand was definitely having a negative impact on his business.

As seen in the following chart, Reed's Clothiers inventory turnover ratio of 2.9, which expresses the number of times inventory is sold over a certain time, is extremely low in comparison to the industry average of 7.0. So too is Reed's Clothiers quick ratio, denoting Jim's inability to quickly convert any of his other current assets (excluding inventory) into cash.

There are also similar problems with Reed's Clothiers receivables turnover and average collection period. The low receivables turnover ratio of 4.9 is an indication of the firm's inability to collect on its accounts receivables.

While the firm's average collection period of 74.1 days against the industry average of 47.4 days, is an indication that Jim is allowing his far too much leniency in paying on their credit accounts, a problem that is translation itself over to Reed's Clothiers extraordinarily low payable turnover ratio, a clear indication that the company is struggling to repay its debts.

2. Why does Holmes want Reed's to have an inventory reduction sale, ...

#### Solution Summary

Ratio Analysis to solve Reed's Clothiers Cash Flow Problem - this file contains a formatted MS Word file that illustrates the us of ratio analyis to solve a cash flow problem - this case the example of Reed's Clothier.

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