Don't Let It Happen, Goodyear

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. Or 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 before the holiday season 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 Goodyear Tire & Rubber (NYSE: GT), the tire maker. Here's what the company has reported for the latest four-quarter period, and for the latest 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.

As you can see, two years ago Goodyear let inventory grow quite a lot relative to sales. It seems to have reversed that, though the recent surge in A/R growth is a might worrisome. Titan, however, is letting A/R go all over the place for the past couple of years. And inventory grew a lot a year ago. It seems management has taken its eye off the task of managing these two accounts in a healthy manner. As for Carlisle, it too has had trouble keeping growth in A/R smooth and tied to sales growth. In the past year, you could add inventory growth to that. Seems to be a rough industry to be in, with tire sales linked to auto sales. Still, managers in a cyclical industry should keep tight control of their working capital, of which A/R and inventory are two parts.

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.

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