In the first of a two-part series Leonard Curtis Director Phil Deyes looks at the ‘zombie’ firm phenomenon, what key economic ingredients are needed to create them and how to spot one.

A ‘zombie company’ is the description applied to a business that is only generating enough liquidity to meet operational costs and debt interest payments. This chronic liquidity pattern has usually been going on for some time, with the business burning through cash for nothing other than survival. 

The term was first applied to Japanese firms supported by their banks during the period known as the ‘lost decade’ in around 1990. It then returned to the mainstream after the financial crash in 2008 and then again during the China crash in 2016. The spectre of the ‘zombie company’ now seems to be back again as economies around the world feel the shockwaves of the current Covid-19 pandemic.

So, let’s take a look at the zombie phenomenon in more detail and how such companies may impact upon the economy as we move further into the depths of this pandemic.  

What are the key economic ingredients for the creation of zombie companies?

Particular to the UK, there were five key ingredients that provided the fertile ground for the creation and continuation of zombie companies.

As we now move to the current pandemic, we not only have continued inexpensive credit that is widely available (although the market is now recoiling to a certain extent), but a series of unprecedented financial support and business protection measures to ring-fence businesses still further.

Certain sectors of the economy have been so badly affected by the pandemic, they cannot even service operational costs from available cash, let alone interest-only debt servicing. Ordinarily, these businesses would fold, but the intervention and support measures have protected these companies from the most severe consequences of this crisis, and rightly so for certain businesses.

But problems are indeed emerging, as the levels of financial support and business protection measures diminish at the same time businesses return to a semblance of trading.  They are also starting to recommence operations with an increased debt burden that requires servicing, as compared to pre-pandemic.  The uncertainty around how long these measures will last is also creating unpredictability in the market and anxiety amongst business owners.

Businesses were prepared to borrow cheap money to survive and fund, in many instances, losses in the hope of a V-shaped recovery. Even with a potential vaccine on the horizon, restrictions remain and the recovery is likely to take much longer than perhaps first predicted, leading to the rise and development of  the zombie company.

How to spot a zombie company – what are the tell-tale signs?

In technical terms a zombie company will have an Interest Coverage Ratio (the relationship between the EBIT and interest expense) below one. Once the ratio falls below 1.5, the ability of a company to service debt effectively becomes questionable.

This lack of liquidity has usually persisted for an extended period, with little or no prospect of achieving earnings sufficient to start making capital repayments. In its most chronic form, the position never gets any better.

A toxic balance sheet

There are few signs of growth, no dividends are available to stimulate further investment and long-term prospects are poor. Assets are regularly refinanced and the majority are secured by way of mortgage, asset finance (HP, leasing) or sales ledger finance.

Funds raised are commonly used to replenish lost liquidity within the business rather than to help purchase a capital asset or stimulate growth. There are rarely further free assets, owned outright by the company.

Stagnation and creditor support

Zombie firms tend to muddle through rather than restructure or expand. They will usually wait for someone else to make the first move as regards insolvency and be pushed into it rather than take the plunge themselves. They thrive on persistent creditor acquiescence, as neither financial institutions, HMRC nor trade creditors want to crystallise a loss or suffer a slow and painful exit, waiting for the insolvency practitioner to determine whether a recovery is possible.

As well as the balance sheet and cash generation being poor, they tend to seek extended credit terms or frequently breach existing ones. It’s easier to kick the can down the road. They ask for funds in advance where the contract does not provide for it, as they need to front-load their cash requirements and once they have the cash, often sit back and use the money for other purposes.

They may request early drawdowns from stage payments if it’s a function of their contract, but again may divert the cash onto other projects or expenses. Product quality and quality control tends to slip with increased returns and credit notes. The driver is to generate cash rather than focus on the performance or output of the business.

Haemorrhaging of talent 

Staff turnover tends to increase, as talented people usually see the writing on the wall, or are sometimes not getting paid themselves and have no choice but to move on. Employees tend to bear the brunt of the difficult calls with creditors and customers and eventually get fed up, stressed and decide to call it a day.

Credit Insurance and Extending Year Ends’

Credit insurance usually falls away as their performance dips and creditworthiness is shattered. Existing lines of credit get squeezed further and they burn through even more cash as they move to pro-forma or cash on delivery.

They tend to look to extend year ends and file returns late as they don’t want to disclose to the outside world their pitiful financial state or can’t afford to pay for the accounts to be prepared.  

These are classic signs of a distressed or zombie company.

Click here for part two of Leonard Curtis Director Phil Deyes look at the zombie firm phenomenon, this time looking at how they affect the wider economy and what the future holds for business in general.

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