How Well Do You Use Cash, Vonage?

There are two parts to successful investing: finding the winners and avoiding the losers.

But looking just for the former, especially if you focus mostly on revenue and earnings, can leave you exposed to the latter.

In order to fully benefit from your winners, you need to spot the ones to stay away from. After all, a 200% gain is completely wiped out by four other picks dropping 50% each. As for that winner, revenue and earnings are not the place to see trouble coming in time to do some good. You don't want to wait for an ugly earnings surprise that gives your stock a massive haircut before getting out.

That's why just about the first thing I read is the balance sheet. This is where the company's financial health is found and where sickness' warning signs often show up.

One balance sheet tool I like is the cash conversion cycle (CCC). This shows how fast the company turns its cash into inventory, sells that inventory, and then collects the cash on those sales. It's measured in days and, generally, the lower it is, the better. (For details on how it's calculated, check the Foolsaurus investing wiki entry here.) It is possible to have a negative CCC, as Dell showed to great effect for several years. Of course, seeing CCC increase can mean it's a company to avoid or exit.

This metric doesn't apply to every industry, however, such as banks. It's primarily for companies that interact with suppliers and customers, buying from one, selling to the other.

Here are three companies operating in the same industry that recently caught my eye:

Source: Capital IQ, a division of Standard & Poor's, and author calculations. TTM = trailing 12 months. All numbers are in days.

Vonage is really pushing its cash through the business, getting paid well in advance of what it owes anyone. The other two are, as well, though not to the same extent. However, Sprint has been headed in the wrong direction, compared to a few years ago. Investors should look further into that.

Of course, the cash conversion cycle should not be the end of your research, and it's best to follow trends over time. However, it can provide useful pointers to either getting in or staying away.

Go past the obsessive focus on quarterly earnings and you'll be way ahead of the vast majority of the market's individual investors. By learning to calculate and use the cash conversion cycle, you'll more likely spot a deteriorating situation early enough to either avoid the company in the first place or get out before the company "surprises" with a bad earnings report.