WORKING CAPITAL MANAGEMENT CASE 16 REEDS

WORKING
CAPITAL
MANAGEMENT



CASE 16


REED’S CLOTHIER,
INC.

WORKING CAPITAL
POLICY

XXXXX XXXXX, 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 XXXXX XXXXX 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. XXXXX XXXXX 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


PART IV WORKING CAPITAL MANAGEMENT

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, XXXXX XXXXX 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.

XXXXX XXXXX 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.

CURRENT SITUATION

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


CASE 16 REED’S CLOTHIER, INC.

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.



100 PART IV WORKING CAPITAL MANAGEMENT

EXHIBIT 1
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%

EXHIBIT 2
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%


CASE 16 REED’S CLOTHIER, INC. 101

EXHIBIT 3
Reed’s Clothiers Aging Schedule


Days Past Due Amount Percent
(000s)

0–29 132 32.0
30–59 90 21.8
60–89 89 21.5
Over 90 102 24.7
$413 100.0

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

*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 tumover .
cost of sales/total assets
Inventory turnover .
cost of sales/inventories
Payable turnover .
cost of sales/ accounts payable

EXHIBIT 5
Reed’s Clothiers
Year Inventories Net Sales
1991 $378 1,812
1992 411 1,886
1993 452 1,954
1994 491 2,035

QUESTIONS

Be sure to provide quantitative information with your answers, not just a qualitative analysis.

1. What type of inventory control system would you suggest to XXXXX XXXXX?

2. What type of accounts receivable control would you suggest to XXXXX XXXXX?

3. Is the increase in sales related to the increase in inventory? (See Exhibit 5.)

4. What is Reed’s cost of not taking the suppliers’ discounts?

Submitted: 1087 days and 6 hours ago.

Category: Homework

Status: CLOSED