Is This Company About to Fail?

It wasn't that long ago that the credit market was exceptionally tight. In spite of (or perhaps because of) Uncle Sam's help, almost no company that actually needed a loan was able to get one from a private lender at decent rates.

In fact, those that could get money at all were forced to pay outrageous interest for the privilege. General Electric, for instance, is paying Berkshire Hathaway 10% on its preferred shares, and GE had to sweeten the pot with warrants to get its rate that low.

And GE is a profitable industrial titan -- once the world's largest company -- which, even after its downgrade, still sports an impressive AA+ debt rating. When a company like that needed to dilute its shares to get a loan at double-digit rates, you know the credit market was tight. Although it was difficult and expensive, GE could borrow the cash it needed to operate. These days, not everyone is so lucky.

Who's the most at risk?
The credit market remains tricky. And in a tricky credit environment, companies that can't either roll over their debt, or pay their debt and operate with what they have, are in danger of going under.

But with the possible exception of law firms that handle bankruptcies, nearly every company is feeling the pain of this economic downturn. So how can you tell whether a company is struggling just like everyone else -- or about to fail?

These three signs should make you sit up and take notice:

• Substantial debt. Given this credit market, a company with significant debt that it can't pay off is a huge risk for shareholders.
• Negative tangible book value. This means that a company's total worth is tied up in its brands, its goodwill, and its ability to generate cash, leaving nothing physical to borrow against.
• Negative earnings. These signal that the company hasn't been able to run its business profitably in recent quarters.

When you put all three of those high-risk signs together, you get companies like these:

Data from Capital IQ, a division of Standard & Poor's. TTM = Trailing 12 months.

Of course, not every company that shares these traits is on the verge of failure, and I'm not suggesting that the above companies are literally about to fail. SIRIUS XM, for instance, seems to be finally turning the corner after the huge start-up costs, expensive early talent, and customer acquisitions that made its past performance look so poor.

Similarly, Sprint Nextel, Hertz, and Virgin Media operate in capital intensive businesses. Their financial conditions are at least partially reflections of the accounting treatment of their continual capital investments. Likewise, Masco's pain looks to be a reflection of both the still weak housing market and an asset write down, and Boston Scientific's woes are also partially due to asset write downs and a major legal settlement.

On the other hand, those three signs in combination often tell of darker days to come. Perennially suffering Rite Aid has long been rumored a bankruptcy risk, for instance, and its inability to right itself has led to its shares to deep into penny stock territory.

If a company is in debt, doesn't have enough assets to borrow against, and isn't earning profits, then it's only a matter of time before its debt holders get tired of financing its business. That's especially true now.

Know when to fold them
In general, companies that hemorrhage cash, have weak balance sheets, and are drowning in debt make lousy investments for shareholders, but they just might be fabulous stocks to short. Of course, shorting isn't for everyone, since your upside is limited to the point where the shares drop to $0, and the strategy brings with it the chance to lose more than you've invested. But if you're going to consider it, where better to look than among companies with weak financial positions?

If you're looking to short individual stocks for big gains (or even identify potential time bombs in your portfolio), enter your email in the box below. We'll send you our latest research the instant it's published -- plus, we'll also send you a brand-new, absolutely free report, "5 Red Flags -- How to Find the BIG Short," prepared for you by our resident forensic accountant, John Del Vecchio, CFA. Simply enter your email in the box below now.