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

Questions
&#61607; 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.
&#61607; 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?

#### Solution Preview

...be beneficial to the company if the turnover is small.

By comparing Reed's results with industry averages, we can see that Reed does not utilize its asset and inventory as much as the industry. Though their payable turnover is lower than the industry, it might be because its inventory turnover is low.

Total asset turnover = Cost of sales/Total assets
= 1,428/1,591 = 0.90 1.9

Inventory turnover = Cost of sales/Inventories
= 1,428/491 = 2.91 7.0

Payable turnover = Cost of sales/Accounts payable
= 1,428/205 = 6.97 15.1

Profitability Ratios

The profitability ratios are the ratios that are used to measure the profitability of the company's operation in the particular year. Gross profit margin and net profit margin will determine the profit for the company's operation. Return on common equity will determine the return for the shareholders.

By comparing Reed's results with industry averages, we can see that Reed's gross profit margin is slightly below the industry average. However, its net profit margin and return on common equity is much lower than the industry averages.

Gross profit margin = Gross Margin/Sales
= 607/2,035 = 29.83% 33.0

Net profit margin = Net Income/Sales
= 85/2,035 = 4.18% 7.8

Return on common equity = Net Income/Common Equity
= 85/530 = 16.04% 25.9

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

Holmes wants Reed's to have ...