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 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 TriQuint Semiconductor (Nasdaq: TQNT), the semiconductor company specializing in smartphone components. Here's what the company has reported for the past four-quarter period, and for the past two year-over-year periods. I've also included a couple of others for comparison's sake.

Metric

TriQuint Semiconductor

PMC-Sierra (Nasdaq: PMCS)

Atheros Communications (Nasdaq: ATHR)

Revenue growth, TTM

21.1%

20.1%

82.2%

A/R growth, TTM

12.7%

75.7%

97.8%

Inventory growth, TTM

13.0%

36.6%

146.9%

       

Revenue growth, year ago

27.3%

(3.9%)

(4.4%)

A/R growth, year ago

33.5%

0.9%

(38.0%)

Inventory growth, year ago

(19.6%)

(32.7%)

(22.9%)

       

Revenue growth, 2 years ago

10.8%

18.5%

25.5%

A/R growth, 2 years ago

12.9%

22.2%

52.5%

Inventory growth, 2 years ago

37.8%

32.9%

58.7%

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

For high-tech companies, especially, Foolish investors will keep an eagle eye on inventory and A/R growth. Inventory becomes obsolete rather quickly, so it is usually a bad sign if its growth exceeds that of revenue, especially over an extended period of time. Except for a couple of years ago, TriQuint has done pretty well in managing these parts of working capital. No immediate worries there. PMC-Sierra has handled inventory reasonably well but let its let A/R growth get a bit out of hand over the past year. Investors should track that going forward. Atheros has been running a bit closer to the edge, letting both inventory and A/R grow too fast a couple of years ago, followed by letting inventory grow too fast again over the past year. Trouble ahead? I don't know, but if I owned shares, I'd do a bit more digging to see what's been happening.

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.

Atheros Communications is a Motley Fool Hidden Gems recommendation. The Fool owns shares of Atheros Communications. Try any of our Foolish newsletter services free for 30 days.

Fool analyst Jim Mueller doesn't have a position in any company mentioned. He works with the Fool's Stock Advisor newsletter service. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool is investors writing for investors.