How Well Do You Use Cash, Baxter?

There are two parts to successful investing: Finding winners and avoiding losers.

But looking just for the former, especially if you focus mostly on revenue and earnings, can leave you exposed to the latter.

In order to fully benefit from your winners, you need to spot the companies to avoid. After all, a 200% gain is completely wiped out if four other picks dropp 50% each. As for that winner, revenue and earnings are not the place to see trouble coming in time to do some good. You don't want to wait for an ugly earnings surprise to give your stock a massive haircut before you get out.

That's why just about the first thing I read is the balance sheet. This is where the company's financial health is found and where sickness's warning signs often show up.

One balance sheet tool I like is the cash conversion cycle (CCC). This shows how fast the company turns its cash into inventory, sells that inventory, and then collects the cash on those sales. It's measured in days, and generally, the lower it is, the better. (For details on how it's calculated, check the Foolsaurus investing wiki entry.) It's possible to have a negative CCC, as Dell showed to great effect for several years. Seeing CCC increase can mean that a company could be headed for trouble.

This metric doesn't apply to every industry; banks are a notable exception. It's primarily for companies that interact with suppliers and customers, buying from one and selling to the other.

Here are three companies operating in the same industry that recently caught my eye:

Source: Capital IQ, a division of Standard & Poor's, and author calculations. TTM = trailing 12 months. All numbers are in days.

Maybe its relative size gives it an advantage, but Baxter clearly outpaces its two competitors here, both in absolute speed -- it's cycling through its cash nearly 43 times a year -- and the direction that cycle has been moving. If I were an investor in ICU Medical, I'd want to investigate further why the company's taking longer today than it did one and three years ago to cycle its cash. Omnicell is mostly moving in the right direction, but it has a long ways to go to get to Baxter's level of efficiency.

Of course, the cash conversion cycle should not be the end of your research, and it's best to follow trends over time. However, it can provide useful pointers to either getting in or staying away.

Go past the obsessive focus on quarterly earnings and you'll be way ahead of the vast majority of the market's individual investors. By learning to calculate and use the cash conversion cycle, you'll more likely spot a deteriorating situation early enough to either avoid the company in the first place or get out before the company "surprises" with a bad earnings report.

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