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:

Source: 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.

SBA Communications, for instance, owes at least part of its losses to a charge related to early debt repayment. And Clear Channel Outdoor seems to be turning the corner, helped in large part by the stabilization of the advertizing market.

On the other hand, those three signs in combination often tell of darker days to come. United Continental and AMR are both airlines, and that industry has seen more than its fair share of bankruptcies. Similarly, as a homebuilder, Hovnanian needs that industry to recover to have any real chance of recovery, and given the music business' ongoing digitization, Warner Music may not be long for this world.

Likewise, Level 3's recent convertible debt offering isn't exactly a sign of corporate strength, as it showcases both the company's continuing weakness and the risks to shareholders of such dilutive financing.

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.

Buy smarter
In general, companies that hemorrhage cash, have weak balance sheets, and are drowning in debt make lousy investments. On the flip side, those that gush cash, make smart use of debt, and have solid balance sheets backing up their businesses can be tremendous companies to own.

That's especially true during troubling times, when virtually every company has been knocked off its peak, and even some of the strongest ones are available at bargain-basement prices.

At Motley Fool Million Dollar Portfolio, we're actively scouring the market to find the solid companies whose shares have been left to rot alongside the truly damaged ones. When we find those diamonds in the rough, we share them with our members, who then have the opportunity to buy some of the world's greatest companies at bargain prices, as we invest the Fool's money alongside them.

If you're ready to avoid the companies teetering on the edge of failure, and instead focus on those with the fundamental strength to thrive in the long run, consider joining us at Million Dollar Portfolio, a real-money portfolio designed to help you craft a collection of investments that work together. Simply click here and enter your email address to learn more.

This article was originally published March 10, 2009. It has been updated.

At the time of publication, Fool contributor Chuck Saletta owned shares of General Electric. The Motley Fool owns shares of Berkshire Hathaway, which is both a Motley Fool Stock Advisor selection and a Motley Fool Inside Value pick. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool has a disclosure policy.