Reeds Clothier Inc - Essay Example

Reed’s Clothier Inc. Harold Holmes, the new banker with whom Jim Reeds II, the owner of Reed’s clothier Inc. has to deal now has told Jim that his company’s finances are in real bad shape. Not only that the bank with which his company has been working for past so many decades is not willing to extend the line of credit, also, the amount payable to the bank by the company is due in another 30 days. $130,000 is due in a month’s time. The suppliers are also to be paid and the bank’s line of credit which was Jim’s last hope is not available now. The banker has suggested that Jim reconsider his inventory planning and cut short the expenses in this way. Jim is in trouble and needs to think clearly to find the best solution for his company. The company is making sales so this is not an unsolvable issue. All he needs is a better financial planning. To see the actual situation of the firm, we can move forward and discuss Jim’s financial ratios. The first and most important ratio is the current ratio. This gives an idea of liquidity of the firm. It is not good not to be liquid or to be extremely liquidated. The best balanced sheet has a combination of fixed and current assets. Too many of receivables are not good although they may increase the value of assets but they indicate a weak receivable control system. The industry current ratio is 2.7, while for Jim’s company it is 2.01 (Calculated by dividing current assets with current liabilities) Quick ratio for the industry is 1.6. For Jim Reed’s company it is 1.4. 1 : 1 is the least acceptable ratio. Reed’s is lagging behind in both these ratios from industry standards. Another ratio that proves and shows that the Reed’s company is in bad financial shape is Receivable turnover. If this ratio is high, it indicates higher credit policy. If this ratio is low, it shows there are loopholes in receivables policy. The value for industry is 20.1 while this company has the ratio of 26.0. This once again indicates that due to lack of attention, the company finances are suffering. (White, Sondhi and Fried, 1997) Inventory turnover needs to be high as that indicates good sales against inventory. The figure for industry is 7 which is good. The exhibit 5 show that in case of Reed’s the sales are related to inventory, but with increasing stock the increase in sales is not correlation. These ratios point out the loopholes in the performance of this company. It is not handling its receivables, its inventory and its current assets properly. As one of the problems the company is facing is inventory storage and sales against inventory, by reducing the inventory the storage costs as well as the purchase costs will be reduced. The purchases, interests and principal payments are eating away the finances of this company. By reducing inventory, the costs will b reduced considerably and the financial statements will become favorable for Reed’s. Loose working capital policies are never good. The companies loose a lot if their credit policy is not tight. With a tight credit policy, the sales made on credit are very soon converted to cash and thus the positive cash flow increases. If the sales are made on credit and the cash is not recovered, it is a serious issue. In the quest of making better sales, Reed’s Inc. people have paid less attention towards receiving the cash back. This is now a serious issue for Jim Reeds. Although by converting the receivable into cash, and by changing the working capital policy, the business will prosper; but it will not have a very big impact over the sales. It is a financial policy. Its effects on overall business can be felt and noticed. It affects sales in the sense that by changing the inventory policy and by changing purchase schedules, the sales will be effected. If the inventory is reduced by some 25-35 percent, the sales will be reduced only by 5% but the cost of keeping the inventory will reduce considerably hence resulting in positive cash flow. Jim Reeds need to pay serious attention towards alternate ways of making profit. Gross profit margin needs to be increased by reducing the costs incurred. Thus a tighter working capital policy is definitely needed here. The income statement would be as follows: Reed’s Clothier Inc. Income Statement in (000s) For the year ending June 30, 1995 Net Sales 1938 Cost of goods 1357 Gross profit 581 General and administrative expenses 374 Depreciation and amortization 32 Interest Expense 63 Earnings before taxes 112 Income Tax 43 Net Income 69 Keeping the above discussion in view and keeping the financial planning and working capital management rules in view, it is important that Jim reed’s company changes its inventory control policy. The policy could be changed by looking into the industry best practices. Industry best practices will guide this company towards saving it from going bankrupt. In fact, the company is making good sales. The actual problem of this company is not related to reduced sales. The actual issue here is the poorly managed inventory system and the loopholes in receivable systems. Look at the exhibits 3 and 5. These show the percentage of inventory in the storage. Almost one fourth of the inventory has been in store for more than 90 days. Now if we calculate the cost of keeping this inventory safely stored as compared to the profit the sales of this inventory will generate, we will be able to see a clear loss. Thus I would suggest that the banker’s advice to Jim was good. Jim Reed’s company needs to reduce the inventory. In the earlier phase of expansion increasing inventory was a good idea as according to that situation the increase in sales was directly related to inventory storage. Now the stored inventory has reached a saturation point and it is more of a trouble than beneficial. So at this point in time, the company should go for smaller inventory purchases. Another major issue for the company is its very weak accounts receivable system. As the ratios calculated earlier and provided in the exhibits prove, the company has paid more attention towards making sales even if those are on credit, than receiving the accounts still to be received. The high amount of accounts receivable is a major issue here. If the accounts receivable are cleared, the positive cash flow will increase. There should be a positive cash flow policy. The buyers should be given a discount on timely payment. There are many ways of giving attractive rebates to the buyers so that they are inclined to clear the payments due on time. By doing this the receivables will be decreased and positive cash flow will be increased. The industry routine is net/30 which is same as the discount Reed’s is offering. But the actual loophole is the lack of follow up. The policy should be adhered to strictly to bring the company out of this trouble. Jim Reeds II is not wrong in making this Judgement that inventory and sales are related to each other. If the rest of the financial figures were in the right place, it would have been the best idea to keep the inventory levels high; but not as high as Jim Reed’s company is trying to maintain. Net profit is not only related to number of sales made. It also includes the expenses. The expense the company has to bear due to the storage of these inventory items is higher than the profit it can bring. So the amount of inventory that has been in the storage for more than 90 days must be reduced in the annual cycle. At present the financial state of the company is not very stable and thus it is a must that the company tries to reduce its cost. One of the biggest financial set backs Reed’s Clothier has encountered due to the lack of positive cash flow is that this time around the company has not been able to take advantage of the cash discounts by making prompt payment to the suppliers. Reed’s purchased 80% of the stuff on terms of 3/10, net 60. In usual circumstances the firm has saved a lot of money by making all payments on time. Now the company is in trouble and as the dues of suppliers were long due, Reed’s paid them late and wasn’t able to take advantage of the discounts. As there was a discount on 80% of purchases of 3% if paid within 10 days of purchase, at least 3% of the 80% purchases have been paid extra here. Overall, this company needs to tighten its inventory control policy as well as its accounts receivable policy. References: 1. White, G. I., Sondhi, A. C. and Fried, D. (1997) Analysis and Use of Financial statements. John Wiley and Sons. Pp 123-145 Read More