What it means
The usual test is the interest coverage ratio, which compares a company's operating profit with the interest it owes. A firm whose operating profit is below its interest bill for a sustained period, often several years in a row, is a typical zombie.
Zombies can survive for a long time when borrowing is cheap or when banks would rather extend a loan than admit it will never be repaid. Lenders sometimes prefer this because writing off the loan would force a loss onto their own accounts, a practice often called evergreening (continually renewing a weak loan so it never has to be recognised as bad).
The economic damage is subtle. A zombie keeps competing on price, hiring staff and buying supplies, which can squeeze the margins of healthy competitors and slow the movement of capital to better ideas.
A sector with many zombies often shows weak productivity and low prices. For a manager, the practical question is whether a customer, supplier or rival is a zombie.
A zombie customer may stop paying with little warning, a zombie supplier may fail mid-contract, and a zombie competitor may cut prices below any sustainable level. Analysts screen for zombies using several signals together rather than one number.
These include interest coverage below one, a falling cash balance, repeated debt refinancing, flat or shrinking revenue and a heavy reliance on short-term borrowing. One nuance is that a low coverage ratio alone does not make a company a zombie.
A young company investing heavily may have weak coverage for a good reason, and a cyclical firm may have a single bad year. What marks a true zombie is that the weakness is persistent and there is no credible plan to reverse it.
In practice
Real-world examples.
Example
A regional building materials supplier has posted interest cover of 0.7, 0.8 and 0.9 over three years. Its bank keeps extending the loan each year rather than demanding repayment. A competitor notices the supplier is underpricing contracts and starts to lose bids.
Example
A software company's procurement lead reviews a small vendor that supplies a key component. The vendor's accounts show shrinking revenue and a refinancing every six months. The lead adds a second supplier as a safeguard in case the vendor fails.
Example
A central bank economist studies why productivity has stalled in the retail sector. She finds that a growing share of the sector's firms cannot cover their interest from operating profit. She concludes that cheap credit may be keeping unproductive businesses alive.
Formula
Calculation
Interest coverage ratio = Operating profit (EBIT) / Interest expense
EBIT stands for earnings before interest and tax. Suppose a manufacturer reports EBIT of $400,000 and interest expense of $500,000 for the year. Interest coverage = 400,000 / 500,000 = 0.8. Because the ratio is below 1, the company earns only 80 cents of operating profit for every dollar of interest, and it must borrow or sell assets to cover the gap of 500,000 - 400,000 = $100,000. If this repeats for several years, the firm is a zombie candidate.Case study
Seen in the real world.
Brightfield Appliances is an illustrative, fictional manufacturer with $20,000,000 of debt and annual operating profit of $1,200,000. Its interest bill is $1,500,000, so cover has sat at 0.8 for four years and the company has survived only by refinancing each loan as it falls due.
A new finance director takes over and builds a three-scenario plan. The first assumes nothing changes, which leaves the firm unable to repay anything. The second sells a loss-making division to raise $4,000,000, and the third negotiates a debt-for-equity swap.
The board chooses a mixture of the second and third routes. The illustrative lesson is that a zombie can recover, but only when someone forces a decision rather than allowing the loans to roll over indefinitely.
Watch out
Common mistakes.
- Labelling any company with one weak year as a zombie, when the test requires persistent weakness over several years.
- Assuming zombies are always tiny, when large and well-known firms can also be unable to cover their interest from operating profit.
- Treating an extended loan as proof of health, when repeated refinancing of a weak borrower can simply hide a loss.
Questions
People also ask.
What is the quickest way to spot a zombie company?
Check whether operating profit has been lower than interest expense for several consecutive years, then look for repeated refinancing and a shrinking cash balance.
Are zombie companies a risk to suppliers and customers?
Yes, because they can stop paying or fail suddenly, so careful credit limits and a backup supplier are sensible precautions.
Why do lenders keep zombies alive?
Calling in the loan would force the lender to record a loss, so extending it can look cheaper in the short term even though it makes matters worse later.
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