Indecent Inventory Exposure

As the economic slowdown sinks its teeth deeper into businesses, many investors -- including this one -- have become overwhelmed with slowing revenue and earnings growth. Those metrics, found on the income statement, only begin to reveal the health of a company's business. To find out the whole story, one must examine the balance sheet and the cash flow statement.

Last week, we concluded that personal finance software vendor Intuit (Nasdaq: INTU) had strong revenue and earnings growth, but its inability to grow its core business was unacceptable. That was obvious because Intuit had a negative Cash King Margin and produced very little cash from operations. If we had framed our analysis around earnings and revenue, however, the conclusion would've been much different.

A strong balance sheet and cash flow statement have even greater significance during difficult times, whether company-specific or related to the economy. Not only does increasing cash and sparse debt afford businesses the ability to withstand potential problems, but also to continue making investments that maintain competitive advantage. In fact, a company that continues investing in product improvements faster than the competition would be well-positioned to acquire additional market share.

The cash-to-debt ratio and the Foolish Flow Ratio are two ways to measure the health of a company's balance sheet. The former is important because it helps indicate if a business is growing its earnings from operations, freeing it from having to make interest payments. The latter indicates how well a company is managing working capital (current assets and liabilities) and if cash is being used efficiently.

A significant increase in inventory can force the Foolish Flow Ratio upward. Recently, Cisco Systems (Nasdaq: CSCO) reported second-quarter revenue growth of 55% with accounts receivables and inventory increasing 105% and 262%, respectively. Those increases boosted Cisco's Flow Ratio to 1.28, above our 1.25 target, with the main culprit being inventory growth.

Specifically, Cisco found itself with excessive raw materials inventory. Like most manufacturing companies, Cisco has three major types of inventory: finished goods (product ready to ship), work in process (partially assembled product), and raw materials (unassembled components). Additionally, Cisco has a less-common fourth variety of inventory -- demonstration systems.

Insights can be found by looking at the dynamics among each of these varieties of inventory. For example, an increasing amount of finished goods inventory could signal a lack of end-user demand. On the other hand, an increase in raw materials inventory might signal increasing demand, as a company gears up for production.

Here's the growth breakdown of Cisco's inventory components over the past year:

$ in millions            1/00    1/01  Change
Finished products        $496    610      23%
Work in process           472    902      91%
Demonstration systems     119    80      -33%
Raw materials             145    941     550%

As you can see, the real damage was in the raw materials department. According to Cisco management on its last earnings conference call, the company had committed itself to long-term purchases of raw materials based on the then-budgeted 65% revenue growth. When the economy turned down suddenly in December, growth of only 55% materialized, and Cisco was left holding the bag on a significant chunk of raw materials inventory.

In Cisco's latest 10-Q, released earlier this week, management said this about its inventory: "The increase in inventory levels reflected new product introductions and increased purchases to secure the supply of certain components with long lead times, combined with the decrease in demand of products due to certain unfavorable economic conditions."

In some cases, inventory is a necessary evil because businesses must have the ability to deliver finished goods on demand. Too much inventory, however, can be risky, particularly in high-tech industries, where rapid technological change breeds product obsolescence. That could force Cisco to take a charge for its excess inventory or slash prices. In either case, the company's gross margins will most likely begin to fall