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.

BACKGROUND
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 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 is cost of not taking the suppliers€™ discounts?

EXHIBIT 1
Reed€™s Clothiers Income Statement (in 000s)

Exhibit 3

Exhibit 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
Exhibit 5
Reed€™sClothiers

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Common Size Reed's Industry 100% 67.0 33.0 18.2 100% Net Sales Cost of Goods Gross proft General & Administrative $2,035 1.428 70.2 S607 29.8 18.4 374 xpense.s Depreciation & amortization Interest expense Eamings before taxes 1.6 32 63 138 53 S85 0.9 12.7 Income laxes 2.6 4.9 Net income EXHIBIT 2 Reed's Clothiers Balance Sheet (in 000s) Reed's 1.0% 30.9 26.0 57.9 Common Size Industry 1.5% 20.0 20.1 41.6 Cash Inventories Accounts receivable Total curent assets Fixed assets S17 491 413 S921 670 S1,591 S205 234 100.0% 12.9% 14.7 100.0% 9.3% 6.4 Total assets Accounts payable Notes payable Other current liabilities Total current liabilities Long-term debt Total liabilities Stockholders' equity Total liabilities and stockholders' equity S457 28.7 15.9 604 66.7 33.3 100.0% S1,061 46.3 S1,591 100.0% Reed's Clothiers Aging Schedule Days Past Due Percent Amount (000s) 132 90 0-29 30-59 60-89 Over 90 32.0 21.8 21.5 24.7 100.0 89 S413