Don't Let It Happen, Stryker

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 (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 write down 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 Stryker (NYSE: SYK), the medical device company. Here's what the company has reported for the past four-quarter period, and for the past 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.

Stryker has managed these two lines of its working capital fairly well over the past three years, only once letting inventory get a bit ahead of revenue some two years ago. That's since been brought back under control.

The same can't be said for the other two companies, though. St. Jude let A/R growth get ahead two years ago and then let inventory growth surge a year ago. The last year's been better, but the past could come back to haunt it if management's not careful. Zimmer had an inventory growth issue a year ago that might have come back under control. A couple more quarters will likely tell investors whether that's indeed the case or not.

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.