Alcoa (NYS: AA) carries $5.3 billion of goodwill and other intangibles on its balance sheet. Sometimes goodwill, especially when it's excessive, can foreshadow problems down the road. Could this be the case with Alcoa?

Before we answer that, let's look at what could go wrong.

AOL blows up
In early 2002, AOL Time Warner was trading for $66.27 per share.


It had $209 billion of assets on its balance sheet, and $128 billion of that was in the form of goodwill and other intangible assets. Goodwill is simply the difference between the price paid for a company during an acquisition and the net assets of the acquired company. The $128 billion of goodwill in this case was created when AOL and Time Warner merged in 2000.

The problem with inflating your net assets with goodwill is that it can -- being intangible after all -- go away if the acquisition or merger doesn't create the amount of value that was expected. That's what happened in AOL Time Warner's case. It had to write off most of the goodwill over the next few months, and one year later that line item had shrunk to $37 billion. Investors punished the stock along the way, sending it down to $27.04 -- or nearly a 60% loss.

In his fine book It's Earnings That Count, Hewitt Heiserman explains the AOL situation and how two simple metrics can help minimize your risk of owning a company that may blow up like this. Let's see how Alcoa holds up using his two metrics.

Intangible assets ratio
This ratio shows us the percentage of total assets made up by goodwill and other intangibles. Heiserman says he views anything over 20% as worrisome, "because management might be overpaying for the acquisition or acquisitions that gave rise to the goodwill."

Alcoa has an intangible assets ratio of 13%.

This is well below Heiserman's threshold, and a sign that any growth you see with the company is probably organic. But we're not through; let's also take a look at tangible book value.

Tangible book value
Tangible book value is simply what remains after subtracting goodwill and other intangibles from shareholders' equity. If this is not a positive value, Heiserman advises you to run away because such companies may "lack the balance sheet muscle to protect themselves in a recession or from better-financed competitors."

Alcoa's tangible book value is $8.8 billion, so no yellow flags here.

Foolish bottom line
Alcoa appears to be in good shape in terms of the intangible assets ratio and tangible book value. You can never base an entire investment thesis on one or two metrics, but there are no yellow flags here. If any companies you're researching do fail one of these checks, make sure you understand the business model and management's objectives. I'll help you keep a close eye on these ratios over the next few quarters by updating them soon after each earnings report.

Keep up with Alcoa, including news and analysis as it's published, by adding the company to your free, personalized watchlist.

At the time this article was published Rex Moore owns none of the companies mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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Gumby

REx Moore like everybody else really ignore the price of aluminium as if it is the norm.... every metal went up manyfold in price look at silver, nickel, moly, copper, tin even lead and zinc... all of those went up except aluminium... Iron ore went up a lot... Everyone is too dependent on ultra cheap aluminium to boost their bottom lines.. Everyone!! want aluminium prices kept down at all costs!! We are burying alumiinium prices and forget it unitl one day finally it catch up only if you give up!

May 15 2012 at 2:54 PM Report abuse rate up rate down Reply
1 reply to Gumby's comment
Patricia

Gumby, ALCOA has long ago given up "giving" metal to the big can makers. That big metal mover must have been difficult to do. They are also getting cheap metal out of Iceland and will soon out of Saudi. Once buisiness picks up I would guess that ALCOA is set to make significant profit even with it's big debt.

May 15 2012 at 9:23 PM Report abuse rate up rate down Reply
Gumby

ALCOA CEO Klaus Klienfeld hailed from Siemens which filed for bankruptcy a few years ago.. Klaus deny any misdeeds whatsoever.. You never know ??? He may be a motrician for all he is worth???

May 15 2012 at 2:50 PM Report abuse rate up rate down Reply
Gumby

I may be talking gibberish so is aluminium prices today.. it is worst gibberish still...

May 15 2012 at 2:47 PM Report abuse rate up rate down Reply
Gumby

ALCOA workers are twiddling thumbs or they know something I dont... maybe they want bankruptcy so to get rid of labor deadwood..???

May 15 2012 at 2:46 PM Report abuse rate up rate down Reply
Gumby

Century Aluminium and Noranda Aluminium along with Kaiser Aluminium is bugging ALCOA everywhere here in America.. too much competition here in America! Century Aluminium is dedicated its whole aluminium production to Glencore and BHP through 2016. maybe will extend long term contracts again . Glencore put Centruy aluminium in warehouses unused.. all 800,000 tons of them every year , I suppose.. Glencore is a metal speculator nothing more.. Glencore is killing ALCOA

May 15 2012 at 2:45 PM Report abuse rate up rate down Reply
Gumby

ALCOA DOWN TO $4 OR SO BEFORE i decide whether ALCOA IS HEADED FOR BANKRUPTCY OR NOT@

May 15 2012 at 2:42 PM Report abuse rate up rate down Reply
Gumby

Pat, China produces close to half of the world annual aluminium!!! Even so, China is replacing aging smelters with new ones .. so fast... The rest of the world is not .. We still have close to 5 millon tons of aluminium stored in warehouses controlled by speculators who work for Boeing, Coca Cola, and General Electric to ensure that aluminium is still ample and cheap! wE pay $2.10 to can recyclers and turn around to sell new can sheets to Coca Cola and Pepsi for $1 a pound or less. Aluminium has gone insane!! ALCOA can go bankrupt if it keeps that way for much longer.. On the good news, we are increasing demand of aluminium but speculators are abetting and aiding money losing aluminium companies around the world with aluminium hoardings as well as cheering them to produce even more... faster than we can use more . I thought that enviormentalists would be up in arms about the great electricity consumption that go to smelters.. Oh no, environmentlaists want cheap aluminium for themselves.. conflict of interest! I would say that $1 a pound is insanely cheap! too good to be true!! But bottom feeders snub at aluminium!! Every investor prefer Boeing, General Electric and Coca Cola over ALCOA... ALCOA is taken advantage of!

May 15 2012 at 2:42 PM Report abuse rate up rate down Reply
Patricia

With all the good indications, why is Alcoa stock less than $9

May 14 2012 at 5:29 PM Report abuse rate up rate down Reply