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 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 Applied Materials (Nasdaq: AMAT), maker of semiconductor manufacturing machines. 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.

Metric

Applied Materials

Lam Research (Nasdaq: LRCX)

Novellus Systems (Nasdaq: NVLS)

Revenue growth, TTM

48.1%

91.2%

55.1%

A/R growth, TTM

104.4%

97.1%

58.5%

Inventory growth, TTM

(9.1%)

36.4%

20.4%

       

Revenue growth, year ago

(34.6%)

(54.9%)

(50.6%)

A/R growth, year ago

(46.7%)

(38.5%)

(55.9%)

Inventory growth, year ago

(5.7%)

(17.3%)

(28.5%)

       

Revenue growth, 2 years ago

(14.5%)

(3.6%)

(21.6%)

A/R growth, 2 years ago

(29.4%)

0.6%

(48.3%)

Inventory growth, 2 years ago

36.1%

19.9%

(1.8%)

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

As you can see, over the past year, Applied Materials has let A/R growth get a bit ahead of sales growth, after having controlled it fairly well over the past couple of years. The decline in inventory also is a bit worrisome, because it marks the second year we've seen such a drop, after inventory surged a couple of years ago. That's something to look at more closely, at least. In contrast, Lam and Novellus seem to be handling these two parts of working capital fairly well, except for Lam's control of inventory a couple of years ago.

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.

To learn more about how we go about analyzing companies, consider taking a 30-day trial subscription to Stock Advisor, the Fool's flagship investing newsletter. 

Fool analyst Jim Mueller doesn't own shares of any company mentioned. He works with the Fool's Stock Advisor newsletter service. The Motley Fool is investors writing for investors.