Is This Company About to Fail?

Just a few months ago, 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 recent 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. But 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 if a company is struggling just like everyone else -- or about to fail?

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

• A substantial amount of debt -- given this credit market, a company with significant debt that it can't pay off is a huge risk for shareholders.
• A negative tangible book value -- which means that its total worth is tied up in its brands, its goodwill, and its ability to generate cash, leaving nothing to borrow against.
• Negative earnings -- which means that it hasn't recently been able to run its business profitably. If that condition doesn't change, those debt holders will soon tire of financing the company's operations.

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.

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. Dow Chemical, for instance, owes much of its losses to the one-time costs of purchasing Rohm and Haas. Similarly, Northrop Grumman, Newell Rubbermaid, Constellation Brands, and Jarden, for instance, owe much of their losses over the past year to asset writedowns. And while that's a sign of overoptimistic expansion plans gone astray, it's not exactly a corporate death sentence.

On the other hand, those three signs in combination often tell of darker days to come. Indeed, Fannie Mae is limping along only after having been bailed out by Uncle Sam. Likewise, in these tough economic times, companies like Lamar that depend on advertising spending are hurting.

If a company is in debt, doesn't have enough assets to borrow against, and it isn't earning profits, then it's really only a matter of time before its debtholders 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 times like these, when virtually every company has been knocked off its peak, and even the strongest ones are available at bargain-basement prices.

At Motley Fool Inside Value, 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.

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, join us at Inside Value. Simply click here to learn more or start your 30-day free trial.

This article was originally published March 8, 2009. It has been updated.

At the time of publication, Fool contributor and Inside Value team member 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 an Inside Value pick. The Fool has a disclosure policy.