How to check for channel-stuffing

Q: What does it mean when a company is said to be “stuffing the channel”? — S.B., Aspen, Colo.

A: When a company stuffs the channel, it ships inventory ahead of schedule, filling its distribution channels with more product than is needed. Since companies often record sales as soon as they ship products, channel stuffing can make it appear that business is booming. In reality, the products not sold may well be returned to the manufacturer. This means sales already claimed may never occur.

To sniff out channel-stuffing, see if a company’s accounts receivable growth is outpacing sales growth. If so, that’s a red flag. Alternatively, calculate “days sales outstanding” (DSO). First, divide the last four quarters’ revenues by 365. Then divide accounts receivable by the number you got. This reveals how many days’ worth of sales is represented by the current accounts receivable. Between 30 and 45 days is typical. You can also follow the same process for the last quarter, dividing last quarter’s revenues by 91.25 (days in a quarter, on average).

A company with a low DSO is getting its cash back quicker and, ideally, putting it immediately to use, getting an edge on the competition. Rising numbers can signify channel-stuffing. Remember that this isn’t useful for all companies. Restaurants and cash-based businesses, for example, aren’t going to have much, if any, receivables.

Q: What does “shrinkage” mean in the business world? — P.B., Greensboro, N.C.

A: It refers to the routine loss of inventory, such as through accidental breakage or theft.

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Fool’s school

The Motley Fool’s eighth annual charity drive is under way. We invite you to learn about and support some wonderful organizations:

Canine Companions for Independence (707-577-1700, www.cci.org) enhances the lives of people with disabilities by providing highly trained assistance dogs and ongoing support. Among other things, the dogs, provided at no cost, help those who can’t perform physical tasks such as opening doors and those who can’t hear things such as telephones or smoke alarms.

First Book (202-393-1222, www.firstbook.org) gives children from low-income families the opportunity to read and own their first new books. An innovator in the field of social enterprise, First Book will celebrate its 30 millionth book this year. One study found that while average middle-class children enjoy more than 1,000 hours of preschool reading, low-income children average just 25 hours.

Habitat for Humanity International (800-422-4828, www.habitat.org) seeks to eliminate poverty housing and homelessness from the world, and to make decent shelter a matter of conscience and action. Since 1976, Habitat volunteers have built more than 175,000 houses worldwide with the participation of the homeowners-to-be. Homeowners’ monthly no-profit, no-interest mortgage payments are used to build still more Habitat houses.

Heifer International (800-422-0474, www.heifer.org) gives economic survival to poor families worldwide by providing livestock and training, enabling them to improve their health, earn money, educate their children and preserve their environment. Recipients give their animals’ first female offspring to other needy people, continuing a chain of sharing, community building and self-reliance from Appalachia to Zambia.

Spirit of America (800-691-2209, www.spiritofamerica.net) helps Americans serving in Iraq and Afghanistan assist people in need. It aims to boost humanitarian activities on the front lines and improve foreign perceptions of the American people. It also supports those advancing freedom, democracy and peace in troubled regions.

Learn more about these fascinating organizations and how to support them at www.foolanthropy.com or via their contact information above. You can also send checks made out to any of the charities above(not to Foolanthropy, please) to us at: Foolanthropy, c/o The Motley Fool, 123 N. Pitt St., 4th Floor, Alexandria, VA 22314. We’ll forward the checks.

My dumbest investment

I decided to invest with the greatest investment leader of all time, Warren Buffett. In 1998, I purchased four shares of Berkshire Hathaway class B stock for $2,680 per share. Now, six years later, the stock is trading around $2,700. My impression is that Warren Buffett is great at giving the appearance of being a very successful money manager. — Igor Alexeff, via e-mail

The Fool Responds: It’s much more than an appearance. Between 1965 and 2003, the per-share book value of Berkshire Hathaway stock increased by an annual average of 22.2 percent. If you had invested $5,000 with Buffett in 1965, you’d be worth more than $15 million today. Still, you’re right that the stock hasn’t marched upward relentlessly. It has been trading between about $1,300 and $3,000 since you bought it. Other great companies have fared similarly. Coca-Cola, for example, has been in a slump since 1998. This is why it’s best to have a long investing horizon, as short-term results are unpredictable. In the long run, if a company prospers, so will its stock. Learn more from Mr. Buffett himself in his enlightening letters to shareholders at www.berkshirehathaway.com.