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 it's the balance sheet that 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 -- a compilation of lessons learned while writing the Quality of Earnings Report, "Wall Street's most exclusive newsletter" -- 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. That can be done for only so long before customers cry "Enough!" and stop buying for a while. Then the company ends up missing revenue and earnings and the stock price gets whacked.

Similarly for inventory. If that is going up significantly faster than sales, that could mean demand is slowing down and a big inventory write-down might be coming. Or sales will be hurt when large markdowns are used just to clear out inventory.

Note, 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. What I'm looking for is when there's 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 makes me dig a bit deeper to see what's going on.

So let's apply this to Medifast (NYSE: MED), the weight management products company. Here's what the company has reported for the last four-quarter period, and for the last two year-over-year periods. I've also included a couple of others for comparison's sake.

 

Medifast

Herbalife (NYSE: HLF)

Weight Watchers International (NYSE: WTW)

Revenue growth, TTM

67.8%

14.9%

(4.2%)

A/R growth, TTM

72.5%

8.5%

(5.8%)

Inventory growth, TTM

35.2%

20.8%

(15.0%)

       

Revenue growth, year ago

36.8%

(6.1%)

(3.7%)

A/R growth, year ago

22.8%

6.1%

(14.0%)

Inventory growth, year ago

1.4%

(5.3%)

(13.3%)

       

Revenue growth, 2 years ago

22.4%

17.5%

12.0%

A/R growth, 2 years ago

13.9%

49.5%

6.2%

Inventory growth, 2 years ago

30.1%

6.0%

(3.4%)

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

As you can see, Medifast has done a pretty good job of keeping A/R and inventory growth pretty much in line with sales growth, or at least not fantastically far ahead. Weight Watchers, too, has been pretty good over the past year. Herbalife has had a bit of trouble controlling A/R growth in the past, but seems to be getting a handle on it in the past year. All in all, no serious red, or even yellow, flags here.

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 as to what could be happening, 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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Fool analyst Jim Mueller doesn't own shares of any company mentioned. He works with the Fool's Stock Advisor newsletter service. The Motley Fool is investors writing for investors.