Calculate a few ratios and compare Reed's results with ...



1. 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 |

|Liquidity Ratios |Reed |Industry |

|Current ratio | 2.0 |2.7 |

|Quick ratio | 0.94 |1.6 |

|Receivables turnover | 4.93 |7.7 |

|Average collection period | 74.08 |47.4 |

| | | |

|Efficiency Ratios | | |

|Total asset turnover | 1.28 |1.9 |

|Inventory turnover | 2.91 |7 |

|Payable turnover | 6.97 |15.1 |

| | | |

|Profitability Ratios | | |

|Gross profit margin |29.8% |33 |

|Net profit margin |4.2% |7.8 |

|Return on common equity |16.0% |25.9 |

If we look at the ratios, we find that Reed is poor on all the parameters. Its current and quick ratio is less than industry and so liquidity is poor. It used more assets than the industry and hence the efficiency in the use of assets is low. It keeps much more inventory and collects cash more slowly and that possible makes the payables turnover low since it pays after a longer time to the creditors.

The profitability is also poor with lower gross margin and net margin. The return on equity is also less than industry average.

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 to have an inventory reduction sale to generate cash. The note is coming due and there is not enough cash to repay then note. Through an inventory reduction sale, which can be on cash basis, Reed can generate enough cash to repay the note. The note is due for $130,000 and the total inventory with Reed is $491,000. With an inventory reduction sale at reduced prices, enough cash can be generated to repay the note.

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?

There is a possibility that it may affect sales. We look at both the inventories and accounts receivables –

1. Inventory – reduction in inventory would imply that at some point in time there may not be the type of inventory that is needed for sales. The possibility of stock out increases. Currently there is a high amount of inventory and so there is very little possibility of stock outs. As the inventory is reduced and if it is not managed properly, there is a possibility that right inventory is not available at right time and so a sale is lost.

2. Receivables – Currently Reed has a very lose credit polity with average collection period of 74.1 days as compared to industry average of 47.4 days. As it tightens the credit policy, there is a possibility that some customers who were buying due to the higher credit period being given may no longer buy from Reed. Once the credit period is the same as industry average, the customers may look at all the suppliers to make a decision.

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.

The income statement is shown below

|Reed Clothiers | | |

|Income Statement | | |

| | | |

|Sales | 1,938,000 | |

|Cost of Goods Sold | 1,298,460 |67.0% |

|Gross Profit | 639,540 |33.0% |

|General and Administrative Expenses | 352,716 |18.2% |

|Depreciation & Amortization | 32,000 |1.7% |

|Interest Expense | 23,256 |1.2% |

|Earning before taxes | 231,568 |11.9% |

|Income Taxes | 94,962 |4.9% |

|Net Income | 136,606 |7.0% |

Sales and depreciation and amortization is as given. The rest of the items have the same percentage of sales as given for industry in Exhibit 1.

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

Reed should adopt an ABC inventory control system. The inventory should be segregated based on the value. High value items as A, moderate value as B and low value as C. This would ensure that more control is exerted over A items then with B or C items. This would ensure that the value of inventory does not rise excessively as well as obsolescence cost is lowered since even if C items become obsolete, the value is low and A items are in any case closely monitored.

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

Jim Reed should control the receivables through the use of Ageing Schedule. An ageing schedule would report past due in respect to each customer. This would ensure that Reed is able to follow up with the customers to collect the past due. With an ageing schedule, relevant information regarding each customer is readily available and so proper targeting of customers can be done so that effort is put for customers which have the most past dues. This would ensure that the past due receivables are reduced.

7. Is the increase in sales related to the increase in inventory? (See Exhibit 16.5.)

|Year | Inventories | Net Sales |Change in |Change in |Inventory as % of|

| | | |inventory |sales |sales |

|1991 |$378 |1,812 | | | |

|1992 |411 |1,886 |8.73% |4.08% |21.79% |

|1993 |452 |1,954 |9.98% |3.61% |23.13% |

|1994 |491 |2,035 |8.63% |4.15% |24.13% |

We put the figures in the table above. What the table shows is that the change in inventory is much higher than the change in sales with inventory increasing as a percentage of sales. Thus there is no direct link to say that sales increase as inventory increases. It would be direct if the percentage change was the same. There could be some correlation, since as more items are kept, there could be a possibility of higher sales but it cannot be said categorically that increase in sales in related to increase in inventory.

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?

Cost of not taking the discount = (% discount/100-% discount) X 365/(Payment days – discount period)

The terms are 3/10 net 60. The cost is

Cost = 3%/(100-3%) X 365/(60-10) = 22.6%

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