Many investors, especially during earnings season, seem to focus on the income statement. How much revenue was there? How much net income was there? Yet that focus can be dangerous, because the balance sheet actually tells us a lot about how the company is doing, and what it's likely to be doing in the not-too-distant future. Today, I'll focus on two balance sheet line items, accounts receivable and inventories, and how they relate to sales.

In Thornton O'Glove's book Quality of Earnings, he calls the analysis of A/R and inventory growth relative to sales the "best method" to get ahead of Wall Street analysts:

One of these simple ploys -- the best method I have ever discovered to predict future downwards earnings revisions by Wall Street security analysts -- is a careful analysis of accounts receivables and inventories. Learn how to interpret these ... a larger than average accounts receivable situation, and/or a bloated inventory. When I see these, bells go off in my head.

If A/R goes up significantly faster than sales, then the company could be stuffing the channel, pulling sales in from the future. It can only do so for so long before customers get fed up and stop buying for a while. Then the company ends up missing revenue and earnings, and the stock price gets whacked.

Similarly, if inventory is rising significantly faster than sales, that could mean demand is slowing down, and a big inventory writedown might be coming. Alternately, sales will be hurt when the company uses large markdowns just to clear out inventory.

Note that I'm not talking about normal business-cycle stuff. Many retailers build up inventory prior to the holiday season in order to meet expected demand. That's normal. Instead, I'm looking for a big disconnect between the growth of sales and the growth of A/R or inventory. That's a potential sign of a risky investment, and it makes me dig a bit deeper to see what's going on.

Let's apply this to Gilead Sciences (Nasdaq: GILD), the biotech company. Here's what the company has reported for the last four-quarter period, and for the last two year-over-year periods. I've also included a couple of others for comparison's sake.

Metric

Gilead Sciences

Shire (Nasdaq: SHPGY)

Novartis (NYSE: NVS)

Revenue growth, TTM

31.3%

7.8%

15.9%

A/R growth, TTM

19.3%

44.2%

8.8%

Inventory growth, TTM

39.9%

39.7%

(9.6%)
       

Revenue growth, year ago

27.4%

6.4%

1.9%

A/R growth, year ago

21.7%

(8.4%)

0.4%

Inventory growth, year ago

13.3%

9.9%

(5%)
       

Revenue growth, 2 years ago

25.9%

37.2%

9.5%

A/R growth, 2 years ago

39.1%

12.1%

14.6%

Inventory growth, 2 years ago

49.4%

(14.6%)

28.4%

Source: Capital IQ, a division of Standard & Poor's; TTM = trailing 12 months.

If you ignore the two-year-ago period, both Gilead and Novartis look like they're perfectly in control. Not so with Shire, which has let both A/R and inventory explode relative to sales over the past year. Management should be concentrating on getting that back in check and setting systems in place so it won't happen again. Yet go back two years, and the performances of the three companies are reversed. Shire was the "good guy" back then, while Novartis and Gilead let things jump a bit ahead. I looked at Novartis' acquisition history, but there wasn't anything large in the year ending June 30, 2008, to account for the faster inventory growth relative to sales. Regardless, management didn't let that situation last very long.

Pay attention to the balance sheet, plug a few numbers into a simple spreadsheet, and, according to O'Glove, you can get ahead of Wall Street. This easy analysis, along with a bit of thought, gives you the potential to save yourself the heartache of seeing your investment get sharply cut when a company reports a "surprisingly" disappointing quarter.

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