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    Reed's Clothier Inc - Working Capital Policy Q1 and Q4

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    In this case study we are asked to complete ratios. Also we are asked to create a formal income statement. These are questions 1 and 4. I need to complete this in an excel spreadsheet.

    See attached file also.

    R E E D ' S C L O T H I E R , I N C .

    W O R K I N G C A P I T A L P O L I C Y

    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.

    Reed's Clothier was founded in 1934 by Jim Reed shortly after he had completed
    his military tour. He had hoped to make a career of the military but during
    the early 1930s the U.S. Army was reduced in size, and there seemed little
    chance that this trend would change in the near future. Jim Reed had loved the
    community near his beloved military school, and he decided to open a men's
    clothing shop that would cater to the numerous Virginia Military Institute
    (VMI) graduates who lived in and around Lexington, Virginia.

    During the first six years, the store barely made enough money to provide
    a living income for Jim and his family. But he could see that sales were growing
    each year and that his primary customer base of ex-VMI graduates was
    growing. Shortly after 1940, he hired his first additional salesman, Leon Hearn,
    a 1909 graduate of VMI who had just retired from the army after 30 years of
    service. After World War II, the business continued to grow and by 1976
    annual sales had grown to $800,000. Jim decided to retire in 1976 and turned
    the company over to his son, Jim Reed II, who had graduated from VMI in
    1960 and served eight years in the U.S. Army, including a tour in Vietnam,
    where he had been wounded. Since 1968, the younger Reed had worked in his
    father's store.

    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.

    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 slowly increasing the line
    of credit at the bank and, during the last year, not taking the cash discounts
    offered by the store's suppliers. Reed's purchased about 80 percent of its purchases
    on 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 suppliers
    were demanding payment with the threat of ceasing deliveries until payment
    was made. This threat had pushed Jim into going to see his banker with the idea
    of increasing his line of credit another $100,000.

    In the past, Jim had only dealt with his VMI classmate at First Virginia
    National Bank, Bob Roberts, and after talking about the good old days at the
    military school, an increase in the line of credit had always been granted without
    Bob ever looking at Reed's financial statements. Today, however, had been
    a different story. Two months ago, Roberts had been promoted to a public relations
    job with the bank and Jim had been introduced to Holmes, who had asked
    to see an up-to-date set of financial statements at their first meeting. In today's
    meeting Holmes had talked about cash flow problems and even mentioned the
    possibility of financial distress. There had been no easy talk about the past or
    how great and valued a customer Reed was, only talk about how they could get
    Reed's on a strong financial footing.

    Holmes had strongly suggested that Jim request the help of a consultant who
    could help him establish a better inventory system. In addition, the condition for
    continuing the present line of credit was payment of the overdue note payable
    within 30 days. Holmes also suggested that Jim reduce his inventories and
    accounts receivables to the industry averages. (See Exhibits 1 and 2 for income
    statement and balance sheet information for the last full fiscal year. Both statements
    have common-size columns for Reed's and the industry.) Jim had argued
    that reducing inventory would reduce his sales and make it even harder to
    become current on his accounts. Holmes had countered this argument by saying
    that he thought his sales would be reduced less than 5 percent annually, and that
    by not reducing the inventory through an inventory reduction sale, Reed's
    would not be able to raise the cash required to meet its financial obligations.

    Finally, Holmes suggested that accounts receivable be reduced by aggressively
    collecting its past-due accounts. (See Exhibit 3.) This was a particularly sore point
    with Jim, for he knew he had allowed his collections efforts to lapse in his efforts
    to increase sales. Jim was afraid that if he aggressively attempted to collect his
    past-due accounts, these customers might become angry and take their business
    elsewhere. Reed's sold about 75 percent of its sales on terms of net 30, which were
    the same terms offered by all its major competitors. As he slowly walked the two
    blocks between the bank and his store, Reed finally realized that his store was in
    serious financial trouble and wondered what he needed to do to regain control.

    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?

    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%
    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%
    Reed's Clothiers Aging Schedule
    Days Past Due Amount Percent
    0-29 132 32.0
    30-59 90 21.8
    60-89 89 21.5
    Over 90 102 24.7
    $413 100.0
    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 tumover 5 cost of sales/total assets
    Inventory turnover 5 cost of sales/inventories
    Payable turnover 5 cost of sales/ accounts payable
    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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    Solution Preview

    Question 1
    Current Income Statement
    Net Sales 2,035
    Cost of Goods 1,428
    Gross profit 607
    General & administrative Expenses 374
    Depreciation & amortization 32
    Interest expense 63
    Earnings before taxes 138
    Income Taxes 53
    Net income 85

    Current Balance Sheet
    Cash 17
    Inventories 491
    Accounts receivable 413
    Total current assets 921
    Fixed assets 670
    Total assets 1,591
    Accounts payable 205
    Notes payable 234
    Other current liabilities 18
    Total current liabilities 457
    Long-term debt 604
    Total ...

    Solution Summary

    The posting has solution to the Reed's Clothier Inc case relating to working capital. It answers only Q 1 and Q4