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 Rite Aid (NYSE: RAD), the drugstore. 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

Rite Aid

CVS Caremark (NYSE: CVS)

Walgreen (NYSE: WAG)

Revenue growth, TTM

(2.6%)

5.3%

6.5%

A/R growth, TTM

66%

(7.6%)

(2.4%)

Inventory growth, TTM

(5.3%)

10.5%

3.2%
       

Revenue growth, year ago

(1.1%)

9.9%

7.6%

A/R growth, year ago

(5.5%)

23.8%

16.8%

Inventory growth, year ago

(14.9%)

17.5%

(2.4%)
       

Revenue growth, 2 years ago

51.5%

48.5%

10.2%

A/R growth, 2 years ago

71.1%

4.1%

19.5%

Inventory growth, 2 years ago

70.2%

3.3%

9.4%

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

The number that leaps out is that huge spike in A/R growth over the past year for Rite Aid. Given how well the company has controlled it and inventory growth relative to revenue growth in the past, however, it could be something like a change in accounting policy. Foolish investors should check out the footnotes to the last 10-Q or 10-K to track that down. Except for the year-ago period, CVS has done a pretty good job, and Walgreen has done a pretty good job, too. All in all, no real yellow flags here, though if you own shares of Rite Aid, it would be a good idea to track down the reason for that spike over the past year.

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.

The warning signs are often there ahead of time. This tool helps you see them.

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