Editor's note: The original version of this article contained errors related to the company's offering, options compensation and dilution, and working capital. A corrected version of the article follows. We apologize for the inconvenience and earlier inaccuracies.

On Thursday, February 10, PortalPlayer (NASDAQ:PLAY) got burned to the tune of a 17% decline, falling $3.47 to $16.75. Why? We'll get to that, but first a little hint.

If you own an Apple (NASDAQ:AAPL) iPod or any other hard disk-based portable music player, chances are you're jamming because of a PortalPlayer product. That's because PortalPlayer supplies Apple, iRiver, Samsung, and Sony (NYSE:SNE) with miniature computer processors complete with control software, referred to as systems on a chip. Given the craze for portal music players -- even I have one and I am far from a gadget geek -- PortalPlayer seems to have been in the right place at the right time.

Looking at the 8-K for the year-end results shows PortalPlayer grew its revenues almost fourfold to $92.6 million. And according to CEO Gary Johnson, IDC Research expects the number of players hitting the market this year to increase from 14 million to more than 20 million. In addition, Johnson spoke about bringing picture and video technology capabilities to the players. Makes sense. Nokia (NYSE:NOK) and Motorola (NYSE:MOT) have been supplying cellular phones with video capability for a while now. In other words, it looks as though there is plenty of room to grow.

But as Fools, we know better than to invest before kicking the tires. And that means looking at the financials to see what's going on. The company has to create value for its shareholders to be worthy of investment.

While reading the 8-K posted on January 20, three things jumped out at me. The first was stock-based compensation. I was surprised that it was 15% of yearly gross profit. This number is likely far higher than it will be going forward (and it had already dropped to 3.7% of gross profit by the most recent quarter) due to a glut of low-priced option exercises following the company's IPO.

The second thing was dilution. There were 4.2 million basic shares outstanding used to calculate earnings per share of $2.46. But there were 18.1 million diluted shares used for the entire year even though 22.1 million shares are outstanding now. The difference in numbers is because of how the average numbers of shares outstanding are reported before and after an IPO. The bulk of the increase in shares outstanding was based on the conversion of preferred stock into about 12.9 million shares.

The final thing that caught my eye was the large accounts receivable balance -- one that's up 403% year over year. But revenue, the appropriate income statement comparable, was up an even higher 442%. No problems there.

It's worth noting that PortalPlayer supplies a design rather than a product. Being at the top of the supply chain does make it vulnerable to long payment lag times (currently 40 days), as in essence the "sustainable" purchasing starts at the bottom-line consumer and trickles upwards. Fortunately, as a design provider requiring few raw materials, PortalPlayer is not significantly beholden on the accounts payable end.

Under this setup, PortalPlayer can generate lots of free cash flow. However, it does have to make heavy investments in research and development (16% of yearly sales) to keep the innovations coming.

The company's biggest risk, though, is simply being so dependent on sales to a few companies -- namely Apple, as of late. On February 7, Synaptics (NASDAQ:SYNA), another supplier to Apple, dropped on news that Apple was fixing to switch from Synaptics' iPod clickwheel technology to in-house goods. One analyst lowered his price target for Synaptics on the spot, but the bigger news splash came a few days later -- February 10 -- when he and another analyst downgraded the company. That news even seems to have awakened fears of a similar fate for also-Apple-dependent PortalPlayer, as its stock's 17% decline -- some of which has since been reversed -- came that same day.

Fool contributor David Meier does not own shares in any of the companies mentioned. The Motley Fool has a disclosure policy.