Case 16: =
Reed's=20
Clothier, Inc.: Working Capital Policy
Jim Reed, II had just left a rather unpleasant =
meeting with=20
his banker, Harold Holmes of First Virginia National Bank. Jim had =
banked=20
with First Virginia for almost 30 years and his father, who had=20
established Reed's Clothier in 1934, had only banked with First =
Virginia.=20
Holmes, however, had just informed Jim that the bank would not =
extend=20
their line of credit any further. In addition, the over due note =
payable=20
for $130,000 must be paid within 30 days. Jim could riot believe =
that=20
Holmes had the temerity to tell him he needed to drastically =
reduce the=20
store's inventory and to strongly suggest an inventory reduction =
sale.=20
Since its founding, Reed has only held the industry's traditional=20
semiannual sales=E2=80=94in January and July. Although Jim was =
piqued by this=20
young banker's demand, the note was over 45 days past due, and Jim =
did not=20
know how he could! make any more than a token payment on the note =
within=20
the next 30 days.
Background
Reed's =
Clothier was=20
founded in 1934 by Jim Reed shortly after he had completed his =
military=20
tour. He had hoped to make a career of the military but during the =
early=20
1930s the U.S. Army was reduced in size, and there seemed little =
chance=20
that this trend would change in the near future. Jim Reed had =
loved the=20
community near his beloved military school, and he decided to open =
a men's=20
clothing shop that would cater to the numerous Virginia Military =
Institute=20
(VMI) graduates who lived in and around Lexington, Virginia.
During the =
first six=20
years, the store barely made enough money to provide a living =
income for=20
Jim and his family. But he could see that sales were growing each =
year and=20
that his primary customer base of ex-VMI graduates was growing. =
Shortly=20
after 1940, he hired his first additional salesman, Leon Hearn, a =
1909=20
graduate of VMI who had just retired from the army after 30 years =
of=20
service. After World War II, the business continued to grow and by =
1976=20
annual sales had grown to $800,000. Jim decided to retire in 1976 =
and=20
turned the company over to his son, Jim Reed II, who had graduated =
from=20
VMI in 1960 and served eight years in the U.S. Army, including a =
tour in=20
Vietnam, where he had been wounded. Since 1968, the younger Reed =
had=20
worked in his father's store.
In=20
1976, Reed's occupied the first floor of a three-story building in =
the=20
heart of downtown Lexington. Reed's used the second floor of the =
building=20
as the store's office and as a warehouse. The third floor, with an =
outside=20
entrance and elevator access, was rented to the law firm of Bundy, =
Hawk,=20
and Harrington. In 1981, Jim decided to expand the retail floor =
space by=20
refurbishing the second floor as a retail shop and using the third =
floor=20
as a warehouse and office. The first floor was then also =
modernized and=20
the store had a very contemporary look and an $880,00 long-term =
mortgage=20
debt.
Jim=20
Reed II had slowly increased the amount of inventory in the store =
with the=20
belief that many sales were lost because an item was not in the =
store when=20
a customer requested it. Sales did grow steadily each year, =
topping $2=20
million in 1994, which bolstered Jim's belief that the increase in =
sales=20
was directly related to the increase in inventory. In fact, sales =
had=20
doubled in the last 10 years, but inventory had tripled over that =
same=20
period of time.
Current=20
Situation
The=20
increase in purchases and the interest and principal payments on =
the=20
mortgage had seriously eroded Reed's positive cash flow in the =
past three=20
years. The cash crunch had been met through a combination of =
slowly=20
increasing the line of credit at the bank and, during the last =
year, not=20
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=20
until this year had always taken the cash discount, but its =
accounts were=20
now almost 40 days past due, and the suppliers were demanding =
payment with=20
the threat of ceasing deliveries until payment was made. This =
threat had=20
pushed Jim into going to see his banker with the idea of =
increasing his=20
line of credit another $100,000.
In=20
the past, Jim had only dealt with his VMI classmate at First =
Virginia=20
National Bank, Bob Roberts, and after talking about the good old =
days at=20
the military school, an increase in the line of credit had always =
been=20
granted without Bob ever looking at Reed's financial statements. =
Today,=20
however, had been a different story. Two months ago, Roberts had =
been=20
promoted to a public relations job with the bank and Jim had been=20
introduced to Holmes, who had asked to see an up-to-date set of =
financial=20
statements at their first meeting. In today's meeting Holmes had =
talked=20
about cash flow problems and even mentioned the possibility of =
financial=20
distress. There had been no easy talk about the past or how great =
and=20
valued a customer Reed was, only talk about how they could get =
Reed's on a=20
strong financial footing.
Holmes had =
strongly=20
suggested that Jim request the help of a consultant who could help =
him=20
establish a better inventory system. In addition, the condition =
for=20
continuing the present line of credit was payment of the overdue =
note=20
payable within 30 days. Holmes also suggested that Jim reduce his=20
inventories and accounts receivables to the industry averages. =
(See=20
Exhibits 16.1 and 16.2 for income =
statement=20
and balance sheet information for the last full fiscal year. Both=20
statements have common-size columns for Reed's and the industry.) =
Jim had=20
argued that reducing inventory would reduce his sales and make it =
even=20
harder to become current on his accounts. Holmes had countered =
this=20
argument by saying that he thought his sales would be reduced less =
than 5=20
percent annually, and that by not reducing the inventory through =
an=20
inventory reduction sale, Reed's would not be able to raise the =
cash=20
required to meet its financial obligations.
Finally, =
Holmes=20
suggested that accounts receivable be reduced by aggressively =
collecting=20
its past-due accounts. (See Exhibit 16.3 .) This was =
a=20
particularly sore point with Jim, for he knew he had allowed his=20
collections efforts to lapse in his efforts to increase sales. Jim =
was=20
afraid that if he aggressively attempted to collect his past-due =
accounts,=20
these customers might become angry and take their business =
elsewhere.=20
Reed's sold about 75 percent of its sales on terms of net 30, =
which were=20
the same terms offered by all its major competitors. As he slowly =
walked=20
the two blocks between the bank and his store, Reed finally =
realized that=20
his store was in serious financial trouble and wondered what he =
needed to=20
do to regain control.
Questions
Calculate a few ratios and compare Reed's =
results=20
with industry averages. (Some industry averages are shown in =
Exhibit 16.4 .) What =
do these=20
ratios indicate?
Why does Holmes want Reed's to have an =
inventory=20
reduction sale, and what does he think will be accomplished by =
it?=20
Jim Reed had adopted a very loose working =
capital=20
policy with higher current assets than industry averages. If he =
merely=20
tightens his working capital policy to the averages, should this =
affect=20
his sales?=20
Assuming that Reed's can improve its =
operations to=20
be in line with the industry averages, construct a 1995 pro =
forma income=20
statement. Assume that net sales will be reduced 5 percent to =
$1,938,000=20
but that depreciation and amortization will not change but =
remain at=20
$32,000.=20
What type of inventory control system =
would you=20
suggest to Jim Reed?=20
What type of accounts receivable control =
would you=20
suggest to Jim Reed?=20
Is the increase in sales related to the =
increase in=20
inventory? (See Exhibit 16.5 .)
What is Reed's cost of not taking the =
suppliers'=20
discounts?