Ratio Analysis to solve Reed's Clothiers Cash Flow Problem

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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, ...