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.

Crown Castle International, for instance, is in the capital-intensive telecommunications infrastructure business, and it owes at least part of its losses to financing costs rather than operational weakness. Likewise, Iron Mountain owes its apparent weakness to asset writedowns. While writedowns are often a sign of overly aggressive investments gone astray, they're rarely a corporate death sentence.

Similarly, while Elan and Lamar have been suffering awhile, their recent earnings reports indicate they may have finally turned the corner. And speaking of turning the corner, even though it's tethered to the long-suffering automotive industry, ArvinMeritor seems to be turning the corner and may well survive even this economy.

On the other hand, those three signs in combination often tell of darker days to come. SUPERVALU, for instance, is being hit with both labor struggles and declining same-store sales on top of its own asset writedown. And while Live Nation has usually been profitable, it is struggling to successfully integrate Ticketmaster while suffering the impact that a weak economy is having on the entertainment industry.

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 enter your email address in the box below to learn more.