Here at The Motley Fool, I've long cautioned investors to keep a close eye on inventory levels. It's a part of my standard diligence when searching for the market's best stocks. I think a quarterly checkup can help you spot potential problems. For many companies, products that sit on the shelves too long can become big trouble. Stale inventory may be sold for lower prices and hurt profitability. In extreme cases, it may be written off completely and sent to the shredder.

Basic guidelines
In this series, I examine inventory using a simple rule of thumb: Inventory increases ought to roughly parallel revenue increases. If inventory bloats more quickly than sales grow, this might be a sign that expected sales haven't materialized.

Is the current inventory situation at Wright Medical Group (Nasdaq: WMGI) out of line? To figure that out, start by comparing the company's figures with those from its peers and competitors:

Company

TTM Revenue Growth

TTM Inventory Growth

 Wright Medical Group 4.2% 4%
 Tornier (Nasdaq: TRNX) 12.7% 21.9%
 Zimmer Holdings (NYSE: ZMH) 5.4% 4.6%
 Kensey Nash (Nasdaq: KNSY) (4.1%) 52.9%

Source: S&P Capital IQ. Data is current as of latest fully reported quarter. TTM = trailing 12 months.

How is Wright Medical Group doing by this quick checkup? At first glance, OK, it seems. Trailing-12-month revenue increased 4.2%, and inventory increased 4%. Over the sequential quarterly period, the trend looks OK but not great. Revenue dropped 2.1%, and inventory dropped 0.1%.

Advanced inventory
I don't stop my checkup there, because the type of inventory can matter even more than the overall quantity. There's even one type of inventory bulge we sometimes like to see. You can check for it by examining the quarterly filings to evaluate the different kinds of inventory: raw materials, work-in-progress inventory, and finished goods. (Some companies report the first two types as a single category.)

A company ramping up for increased demand may increase raw materials and work-in-progress inventory at a faster rate when it expects robust future growth. As such, we might consider oversized growth in those categories to offer a clue to a brighter future, as well as a clue that most other investors will miss. We call it "positive inventory divergence."

On the other hand, if we see a big increase in finished goods, that often means product isn't moving as well as expected, and it's time to hunker down with the filings and conference calls to find out why.

What's going on with the inventory at Wright Medical Group? I've charted the details for both quarterly and 12-month periods.

Wmgi

Source: S&P Capital IQ. Data is current as of latest fully reported quarter. Dollar amounts in millions. FY = fiscal year. TTM = trailing 12 months.

Wmgi

Source: S&P Capital IQ. Data is current as of latest fully reported quarter. Dollar amounts in millions. FQ = fiscal quarter.

Let's dig into the inventory specifics. On a trailing-12-month basis, raw materials inventory was the fastest-growing segment, up 11.6%. On a sequential-quarter basis, raw materials inventory was also the fastest-growing segment, up 3.8%. Wright Medical Group seems to be handling inventory well enough, but the individual segments don't provide a clear signal. Wright Medical Group may display positive inventory divergence, suggesting that management sees increased demand on the horizon.

Foolish bottom line
When you're doing your research, remember that aggregate numbers such as inventory balances often mask situations that are more complex than they appear. Even the detailed numbers don't give us the final word. When in doubt, listen to the conference call or contact investor relations. What at first looks like a problem may actually signal a stock that will provide the market's best returns. And what might look hunky-dory at first glance could be warning you to cut your losses before the rest of the Street wises up.

I run these quick inventory checks every quarter. To stay on top of the inventory story at your favorite companies, just use the following handy links to add companies to your free watchlist, and we'll deliver our latest coverage right to your inbox.