Why Accounts Receivable and Inventories Matter (Fool On the Hill) September 8, 1999

An Investment Opinion

Why Accounts Receivable and Inventories Matter

By Louis Corrigan (TMF Seymor)
September 8, 1999

Investing in stocks requires that you learn some basic concepts and become comfortable working with them. For Fools, this means learning how to analyze business fundamentals since stock prices over time relate quite directly to whether a company's sales and earnings are rising, assets are being managed deftly, and cash is flowing mostly into the corporate coffers where it can be used to buy back stock, fund strategic acquisitions, or do other cool stuff. Each of these interrelated components is captured by a separate section of a company's quarterly 10-Q or 10-K filing with the Securities and Exchange Commission: the income statement (or "P&L," for profit and loss), the balance sheet (assets vs. liabilities), and the statement of cash flows.

The How To Value Stocks section of The Fool School offers an introduction to some of the major terms and some basic ways to use the extraordinary amount of data that public companies must regularly reveal about themselves. Of course, serious number-crunchers can find a dozen ways to run these numbers. And generally, it's preferable if you know how to use the statement of cash flows to reconcile the income statement and balance sheet. That's because what ultimately matters is not a company's reported earnings (which are a product of various accounting conventions, some of which introduce distortions) or the frozen frame picture of a company's balance sheet on that last day of a quarter. What matters is a firm's ability to generate free cash flow over time.

In practice, though, an investor can get a lot of mileage out of simply moving from the income statement -- which novice investors tend to focus on exclusively -- to some key elements of the balance sheet. In our Daily Double and Daily Trouble stock feature, we typically highlight four main balance sheet items. Current cash (including marketable securities) and long-term debt (including long-term leases) give you a quick look at a company's most liquid and obvious current assets and its long-term obligations, respectively. We also include the total current assets and total current liabilities since the difference between these numbers represents working capital, which you need to keep the business running today and in the near future.

We don't list accounts receivable (AR) and inventories, which are important components of current assets. But perhaps we should. Every investor ought to track these numbers over time because they often provide the first glimpse of potential trouble.

The Fool School section on balance sheet matters offers amplified definitions of these components, so I'll just define them briefly here. Accounts receivable is money currently owed to a company by its customers for products or services that already have been delivered. Inventories are components and finished products that a company has stockpiled to sell to its customers

If you think about it, A/R and inventories get included in a company's assets, but in another sense they really are liabilities, as the Rule Maker portfolio has frequently discussed. Indeed, the fact that these assets can quickly become liabilities of a sort is one reason they need to be tracked closely.

What if a company's customers go bankrupt before they've paid off their debts? Well, the A/R would need to be written down (reduced to what the customer can afford to pay) or simply written off altogether as bad debt. Every business deals with bad debtors, but such risks can make A/R a whole lot less substantial than cold hard cash.

The time value of money also comes into play because receivables amount to short-term loans to a customer. Money tied up in receivables, then, is money that can't be used today for other things, whether that's sticking it into the equivalent of a money market account to earn a bit of interest, or using it to fund research or a new marketing campaign -- both potentially higher-return purposes. For these reasons, some companies turn to "factors," parties that agree to buy a firm's accounts receivable at a slight discount to their stated value (say 85% to 95% on the dollar) but accept most or all of the risks of collecting them.

Inventories can be equally suspect as assets, though just how suspect depends on what type of inventories we're talking about. For starters, manufacturers typically break down their inventories into raw materials, work-in-progress, and finished supplies. Of these, one might think that the finished supplies are the most valuable form of inventory since they represent the value-added product of the manufacturer's expertise. But what if we're talking lavender shirts with polka dots and stripes? If the finished goods depend on fickle fashion, they might be worth next to nothing. Raw cotton, however, has a pretty obvious commodity value that you can readily price.

Related though perhaps less dramatic risks apply in high-tech industries where technological changes can occur rapidly. Even four weeks of finished goods inventories may be too much, for example, if we're talking PCs built with 366 Mhz processors and the market has already moved aggressively toward computers built around 400 Mhz processors. Again, there's also the opportunity cost of having money tied up in inventories that are sitting in a warehouse versus having that cash on hand to invest in potentially more rewarding ways.

Also, some risks associated with both inventories and accounts receivables may not be captured directly by a company's balance sheet but may only be apparent from a close reading of the footnotes, other sections of a company's public filings, or even discussions with management (or the investor relations office). For example, manufacturers often offer "price protection" on some portion of the products ("channel inventory") shipped to distributors or retailers. Since just about the entire PC industry deals in fast-depreciating assets, manufacturers must compensate the distributor for certain price cuts designed to move out the old products before the new ones are introduced. Investors need to ask how and to what extent the company is accounting for this obligation because it's a risk that won't appear under "inventories" on the balance sheet.

Similarly, while factoring receivables may make sense from an asset management perspective, you want to know whether the company engages factors on a regular basis and whether the company remains on the hook for any potential bad debt. When a company that doesn't regularly use factors suddenly decides to, it may mean management is trying to hide some serious problems related to its distributors. I've argued that was one way to spot Compaq's (NYSE: CPQ) continuing troubles long before that company finally blew up.

Now clearly, neither receivables nor inventories are bad, per se. They're just part of doing business. But investors need to consider two points. First, companies that can operate with low A/R and low inventories either on an absolute basis or relative to their industry peers are simply better businesses. Companies that can "turn" these assets faster will generate a higher return on invested capital because less of the firm's capital will be tied up in these relatively unproductive areas. (Nasdaq: AMZN) is perhaps the most interesting example both for its overall cash flow dynamics and for its low inventories and virtually nonexistent receivables, particularly by comparison to some of its main brick 'n' mortar peers.

Second, investors need to track changes in A/R and inventories over time and relate them to changes in sales. In general, these numbers should all rise nearly in tandem, with sales gains outpacing these balance sheet items under the best circumstances. Whenever receivables or inventories are rising faster than sales, you want to be cautious, inquisitive, and even skeptical of management's explanations.

For a retailer, for example, it may make sense for inventories to rise slightly faster than sales on an absolute basis. The company may have added lots of new stores so that on a square foot basis inventories may not have jumped at all. Also, inventories may need to rise somewhat in anticipation of increases in same-store sales in future months since you've generally got to have the product on hand to sell it. Yet, inventories growing wildly out of line with sales gains can mean that serious price-slashing and crushing profit margin deterioration could be right around the corner.

Outsized increases in A/R may mean a company's information systems are out of whack, or that the firm is trying to manage around a temporary change in it manufacturing or distribution system. Both present potentially serious risks that can clobber a stock. But the worse-case problem is when a company has stuffed its distribution channel with more products than can be readily sold to end-user customers like you and me. It may have done this to meet Wall Street's aggressive short-term revenue targets, but this just postpones the inevitable decline since the company is borrowing sales from the future to meet today's targets. More than likely, the firm is also offering distributors special discounts to take the product today rather than tomorrow, something that can pressure profit margins, too. When this particular mess becomes apparent, a stock can be crushed. That's because earnings have been driven by essentially phoney sales gains, and projections based on such continued gains must be completely rethought.

The Fool News World offers daily examples that support these generalizations. My main goal here is just to highlight these balance sheet items and suggest that you try to learn how to follow them if you don't already do so. For some relevant examples, though, you might take a look at the following links:

9/3/99: News World: The Sheet Hits the Fan at Pillowtex
3/17/99: Fool On The Hill: Safeskin's Lessons: Being Safe Not Sorry
7/28/98: The Daily Trouble: Gymboree (Nasdaq: GYMB)
7/17/98: The Daily Trouble: CyberMedia (Nasdaq: CYBR)--since acquired by Network Associates (Nasdaq: NETA)