Efficiency Ratios for Reeds Clothiers

Jim Reed II, the owner of Reed’s Clothier, a respected and well known men’s clothing establishment, is facing a huge financial crisis. Jim Reed II is faced with a loss of financing by his family bank, and a 30 day deadline in which he must pay a $130,000 bank note. Jim has a lot of inventory, but does not have a lot of cash, and with only $85,000 Jim must convert a large amount of his inventory into cash in order to meet his pending and future financial obligations.

Jim has put himself into a financial position, and we will follow along to see a solution to get Jim Reed out of his financial crisis.

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?

Financial ratios are a valuable and easy way to interpret the numbers found in statements. Financial ratios can help to answer critical questions such as whether the business is carrying too much inventory or debt, whether the operating expenses are too high and whether the company’s assets are being used in a way to generate income.

In comparing the financial ratios of Reed’s Clothiers to the averages of others in the same industry, it readily becomes clear that Jim’s preference of keeping a large inventory of clothing on hand was definitely having a negative impact on his business.

As seen in the following chart, Reed’s Clothiers inventory turnover ratio of 2.9, which expresses the number of times inventory is sold over a certain time, is extremely low in comparison to the industry average of 7.0. So too is Reed’s Clothiers quick ratio, denoting Jim’s inability to quickly convert any of his other current assets (excluding inventory) into cash.

There are also similar problems with Reed’s Clothiers receivables turnover and average collection period. The low receivables turnover ratio of 4.9 is an indication of the firm’s inability to collect on its accounts receivables.

While the firm’s...