Analyzing accounts receivable and inventory levels is arguably the most widely used method for spotting red flags.

Accounts Receivables

Unlike when they sell to us, a company doesn't usually require payment in advance when it sells to another firm. Instead, it bills the customer and specifies a payment due date. Accounts receivables are the monies owed by customers for goods already shipped and billed. Normally, you’d expect the receivables total to more or less track sales. That is, if sales double, receivables should double also.

You can compare a company’s accounts receivables to an earlier period, or even to a different company’s receivables, by dividing the receivables by sales. You can use either the most recent quarter’s sales, or the last four quarters’ sales in the denominator. The result is usually expressed as a percentage; e.g., 45 percent of sales.

Every industry has its own payment customs, and you can’t compare receivables percentages of companies serving different markets. Many corporations prefer to delay paying their bills for as long as they can because they view those unpaid bills as an interest-free loan. Often, companies within the same industry will exhibit differing receivables percentages due to differences in billing or collection procedures.

Accounts receivables should track sales. Something’s amiss when receivables increase significantly faster than sales. It’s a red flag when you detect that happening. Receivables analysis doesn’t apply to retail stores or restaurants because they sell on a cash basis and they don’t have significant receivables. The reasons receivables can grow faster than sales include:

1. Accounts receivables department falling behind in billing or dunning customers

2. Unhappy customers are withholding payments

3. Channel stuffing

4. Customers cannot pay their bills

In general, the latter two reasons are the more serious, and those are the only two that we will describe in detail. But all we’ll be able to determine from this analysis is that a receivables problem exists, not the cause.

CHANNEL STUFFING

Channel stuffing occurs when a company realizes that it will not meet its sales goals by following its normal practices. At that point, the company devises incentives to spur sales. One approach is to offer customers better terms. For example, it could offer them six months to pay instead of the usual 60 days. If that doesn’t work, the company might offer customers even longer terms, and even better, allow them to return the goods with no penalty if, in the end, the customer decides that it doesn't need the product.

That’s a deal that’s hard to refuse. If accepted, the company ships the goods and the transaction appears on the income statement the same as any other sale, helping the firm meet its sales and earnings numbers for the quarter.

A more extreme example of channel stuffing involves shipping goods that customers didn’t order or even recording nonexistent shipments.

CUSTOMERS CAN’T PAY

The telecommunication equipment industry’s experiences in 2000 and 2001 illustrate a situation where customers wanted the products, but they couldn’t pay for the goods.

In 1998 and 1999, a new breed of telephone companies appeared on the scene. They intended to compete with the entrenched Baby Bell incumbents, and thought that they could teach the old fogies a thing or two about the telephone business. By mid-2000, the young upstarts ran out of cash, and most eventually folded. That left equipment suppliers such as Lucent and Nortel stuck with receivables that would never be paid.

CALCULATE RECEIVABLES SALES P ERCENTAGE

Regardless of the cause, inflated receivables can be easily detected by comparing the most recent receivables/sales percentage to an earlier figure.

Start by dividing the accounts receivables (A/R) total from the most recent balance sheet by the last quarter’s sales, or by the last four quarter’s sales.

receivables percentage of sales = accounts receivables/total sales

Use the most recent quarter’s sales unless there is an overriding reason to use 12 months’ sales. For instance, a full year’s sales might be the best choice for industries with strong seasonal variations, such as patio furniture. Using the last quarter’s sales is easier, and that’s what I usually do.

Except in the healthcare field, accounts receivables typically run between 40 percent and 80 percent of one quarter’s sales, and a number in excess of 100 percent is cause for concern by itself. Firms selling to hospitals and other healthcare providers typically show receivables running as high as 150 percent of quarterly sales.

Always compare the current A/R to sales percentage to the yearago figure. There is no red flag if the current receivables percentage is equal to, or less than the year-ago figure. Variations of 5 percent (e.g., 52 vs. 50) or so are common and not a cause for concern. It’s a red flag if the current quarter’s A/R to sales percentage exceeds the year-ago ratio by 20 percent (e.g., 60 vs. 50), and a potential red flag if the current figure exceeds the year-ago number by 10 percent or higher.

Semiconductor chip fabricator Amkor Technology illustrates the principle. Amkor released its March 2000 quarter results in May when its shares were trading in the low $40 range. Amkor reported that its March quarter sales gained 32 percent and its earnings per share increased 69 percent in March 2000 compared to March 1999.

Amkor’s receivables percentage of sales increased 23 percent (35.3 percent vs. 28.8 percent) in the year, triggering a red flag. In late June, Amkor’s announcement that it wouldn’t meet its June quarter forecasts took its share price down to the low $20s.

If the increase of A/R percentage of sales falls into the 10 percent to 20 percent gray area, compare the A/R percentage to the three previous quarters to get a better feel for the significance of the increase. It’s not a red flag if the latest percentage falls within the range defined by the last four quarters.

The company will often discuss reasons for the increase in receivables in the management’s discussion section of its SEC report. Also, the topic is often raised in the question-and-answer portion of the company’s conference call with analysts following the earnings report. Management always presents a plausible reason for increasing receivables. One common excuse is that a new product line sells to a slower paying industry than existing products. I’ve found that it’s usually a mistake to ignore a receivables red flag.

Inventory Analysis

INFLATED INVENTORIES EQUAL HIGHER PROFITS

Motivated management can manipulate inventory values to artificially boost reported earnings. You have to understand the gross profit calculation to see how that works. The formula for gross margin is:

GM = gross profit/sales where gross profit = sales – cost of sales

Assume that there’s no labor involved in producing a product, only raw materials. Accountants don’t calculate the cost of sales by adding up the cost of the raw materials used to build the products. Instead, they total the value of the inventory on hand at the beginning and at the end of the period. To keep it simple, assume that the firm didn’t buy any raw materials during the period.

If the beginning inventory was $100 and the ending inventory was $50, the cost of sales would be:

cost of sales = $100 – $50 = $50

If the firm sold its products for $75, its gross profit is $25 (75-50). But if the ending inventory is $75 instead of $50:

cost of sales = $100 – $75 = $25

If the firm again sold its products for $75, its gross profit would now be $50 (75-25) instead of $25. You can see that increasing the value of the ending inventory figure on the books can be a tempting way of boosting profits.

INFLATED INVENTORIES CAN MEAN SLOWER SALES

Rising inventory levels (compared to sales) doesn’t necessarily imply creative accounting. Inventory levels can increase simply because the company is producing more than its customers want to buy, causing finished products to pile up. If that were the case, you’d probably see slowing sales growth along with the higher inventory levels. You can analyze inventories by comparing inventory levels to sales, exactly the same as described for accounts receivables. Flash memory maker SanDisk provides an example. In October 2000, with its stock trading around $60, SanDisk reported its September quarter sales up 153 percent year-over-year, and that earnings more than tripled compared to September 1999.

SanDisk’s inventory percentage of sales increased 31 percent (39.4/30.1) year-over-year, solidly in red flag territory. SanDisk’s December quarter results fell short of expectations, and by February, SanDisk’s shares were changing hands in mid-$20 territory. Manufacturing company inventories are usually subdivided into three categories: raw materials, goods in process, and finished goods. A company may stock up on hard-to-get parts in times of shortages, inflat ing raw materials levels. If that’s the case, it will probably be noted in the management’s discussion. Most companies report just a single combined total for inventory, but you can often find a table showing the category breakdown in the SEC report. I rarely look for that data, relying instead on the management’s discussion to point out reasons why I should ignore this red flag.

RETAIL STORES

Retail stores usually don’t have significant accounts receivables. But inventory analysis is equally, if not more, important for retail stores than it is for industrials.

Regardless of whether a store sells clothing or hard goods, much of retail is about fad and fashion. Hot items come and go, and inventory levels increase when customers lose enthusiasm for the stores’ wares. When measured as a percentage of sales, growing retail inventory levels often signal problems.

Most retail store sales are strongly seasonal. Retail store fiscal years typically end on January 31, and January quarter sales are usually double the next highest quarter. Retailers stock up on holiday merchandise prior to Thanksgiving, so the October quarter’s ending inventory levels will always be the highest of the year.

Because retail sales are so strongly seasonal, it’s logical to use TTM sales to iron out the seasonality factors. That works for looking at long-term trends and for comparing competitive chains. For instance, Wal-Mart has been the more efficient operator over the entire period, and had been steadily improving its inventory turns (sales divided by inventory) while Kmart was floundering.

Comparing inventory levels to quarterly sales makes it easier to spot trends. Kmart did the story in reverse. Its January 2001 quarter’s inventory levels improved compared to the year-ago numbers, but Kmart’s performance deteriorated from there.

Comparing inventory levels to quarterly sales gives better signals than using annual numbers, but you have to compare the results to the year-ago percentages, not to recent quarters.

Retail inventory levels generally run between 10 percent and 25 percent of annual sales. Retailers keep a tighter rein on inventory levels than manufacturing companies, so smaller changes constitute a danger signal or red flag. If you’re using annual sales, a 5 percent increase warrants investigation, and 10 percent is a definite red flag. Double those tolerances when you use quarterly sales figures.