Don't Let It Happen, Cirrus Logic

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 Cirrus Logic (Nasdaq: CRUS), the integrated circuit manufacturer that specializes in audio solutions. Here's what it has reported for the last four-quarter period, and for the last two year-over-year periods. I've also included a couple of other smaller semiconductor companies which sit in either the audio or power amplifier space for comparison's sake.

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

Looking at the surface numbers, Cirrus seems to have a bit of trouble controlling inventory growth. Two years ago, it grew about 10 times faster than revenue, and over the past year it more than doubled while revenue only went up about 60%. Granted, it's a relatively small shop, so we're working off a small base here, but still. In the high-tech world, large inventory growth is often not a good sign because product obsolescence can lead to an inventory writedown or show that customers are "double ordering" -- meaning they're placing large orders during times of constrained supply, which can lead to cancellations if the market slows down later.

Another way of looking at this is how many times it goes through inventory per year, called "turns." This past year, it turned inventory 2.8 times using the latest inventory levels, but that's down from 3.8 times over the previous period. Foolish investors should keep an eye on this and probably investigate further. The other two companies aren't lily white, but any situation there doesn't appear to be quite on the same level of concern.

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.

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