As a credit analyst, one of the most important indicators you can track is the ratio of inventory to sales. It's used by money manager and retailing expert David Berman. Berman originally cut his teeth as a CPA, where he learned that inventory accounting was a way managers could manipulate earnings.
Berman points out that companies can let inventories rise over time and thus avoid the markdowns and hits to profits that they should be taking. "Gross margins get inflated," he said, and "earnings accelerate, but cash flow is often negative as inventories build."
So if you see a retailer whose inventory has ballooned from 150 to 350 days over a one year period (these are numbers taken from a real example he cited a while back), that's a big red flag.
In the case he cited, the gross margins had gone up, which on the surface looked favorable. But the company, which he declined to name, was setting itself up for a "catastrophe."
Berman tracks both inventory growth and the number of days inventory will last. The latter, he notes, can determine whether boosting inventory is necessary.
Keep in mind - the same principles hold true for tracking of A/R. A disproportionate rise in A/R can be an equally big red flag, and an early warning sign of trouble ahead.