Don't Let It Happen, Corning

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 zero in on two balance sheet line items, accounts receivable (A/R) 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 Corning (NYSE: GLW), the specialty glass 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.

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

Except for Tyco Electronics' past year, in which the company let A/R growth outpace revenue growth, these three businesses have done a reasonably good job of keeping inventory and A/R growth in line.

For Corning, where investors and analysts have worried about growth, it's good to hear that CFO James Flaws believes that LCD technology's growth story will last longer than expected. "We do not expect to see an overbuild of inventory in the supply chain heading into the fourth quarter," Flaws said less than two months ago. Given management's history of managing these two components of working capital, I'd be inclined to believe he knows what he's talking about.

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, could help spare you 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.