So is Smith & Wesson's (Nasdaq: SHWC) magazine half-full, or half-empty? It depends on how you look at it.

Pessimists might emphasize the fact that the stock is down 22% since the start of this year. Optimists will respond that the stock leapt 15% in response to Thursday evening's earnings report. (And pessimists will respond that the stock has already given back more than half those gains.) But true Fools know better than to judge a company by its fluctuating stock price. What's important is the business behind the stock ticker -- and from this Fool's vantage point, S&W's business is a mess.

The arms-maker lost $0.04 per share in its fiscal third quarter of 2008 (versus earning $0.04 last year). "Economic weakness, reduced consumer spending, lower sales of hunting rifles and shotguns resulting from a hunting season shortened by unseasonably warm weather and a pre-season industry buildup of distributor and retail inventories" combined to shave 630 basis points off gross margin, which plummeted to 25% for the quarter. (Incidentally, that's about what Sturm, Ruger (NYSE: RGR) has averaged over the last year -- so the difference in profitability between the two gunsmiths is rapidly eroding.) Meanwhile, sales grew at their slowest pace of the year, up just 23%. (The sale of related products bearing the S&W brand through Sears (Nasdaq: SHLD) and Wal-Mart (NYSE: WMT), which I suggested last week might hold the key to improving both sales and margins, grew less than 2%.)

The key
Out-of-control inventories hold the real key to all this bad news. CEO Michael Golden says he's "beginning to see positive signs that our industry is improving." But, truth be told, the situation couldn't really have gotten much worse. According to Golden, inventories "increased in November, began to decrease in both December and January and continued to decrease as we entered the fourth fiscal quarter." But after all these ups and downs, inventories piled 51% higher year over year, more than twice the rate of sales growth. Accounts receivable grew almost as quickly, up 34%.

Now, you may recall that the last time management issued guidance (before abruptly "suspending" the practice in January), it had promised to generate $29 million in operating cash flow this year, and spend $16 million on capital improvements. So far, it's been half right. With so much cash tied up in unsold guns and uncollected bills, operating cash flow has evaporated -- but the firm's doing a bang-up job of spending money on capex.

End result: S&W has already burned through $21 million in cash this year. Next to that number, I'd say the quarter's $0.04-per-share accounting loss is the least of S&W's problems.

What did we expect out of S&W last quarter, and what did we find when we checked the chamber? Read about it in:

Fool contributor Rich Smith does not own shares of any company named above. Both Sears and Wal-Mart are Motley Fool Inside Value picks. The Motley Fool has a disclosure policy.