What are Zombie Corporations? Definition and Effects
Zombie corporations are corporations that are deeply in debt but generate just enough income to continue operation or need regular bailouts in order to operate. These corporations are generally able to pay the interest charges on the debts they owe but are unable to repay the principal. With so many corporations struggling to survive after the economic downturn which came about as a result of the covid-19 pandemic, a lot of companies have found themselves in deep debt with some having to declare bankruptcy.
A lot of other companies have found themselves sliding into the zombie corporation category; making just enough to survive in the interim. Here, we shall discuss further on zombie corporations, their features, and their effects on the economy.
See also: Profitability of a Business: How to measure and improve profit
What are zombie companies?
A zombie is a being that should be dead, but, still manages to live. When the term is attributed to companies, they are companies that sold not be existing but are still in operation mostly due the continuous infusion of funds from investors or regular bailouts from banks or even the government. The term originated in Japan in the 1990s when Japanese banks supported Japanese firms that were failing to keep operating after the collapse of the asset price bubble.
The term became popular in the US in 2008 when the U.S Department of the Treasury began the Troubled Asset Relief Program (TARP) to aid restart economic growth, prevent avoidable foreclosures, and stabilize the U.S financial system. The five program areas in which the Troubled Asset Relief Program (TARP) operated include:
- The stabilization of banking institutions
- Helping struggling families avoid foreclosure.
- Stabilizing the global insurance organization, American International Group (AIG).
- Restarting credit markets.
- Stabilizing the U.S auto industry.
Although zombie companies continue to operate, they are usually deeply immersed in depth that they are unable to have any retained earnings that could be used to finance business growth and expansions. Zombie companies can be found among startups, growing companies, and even some mature companies. They emerge as a result of financial crises, economic downturns, and other events that affect economic activities such as the recent Covid-19 pandemic. The Federal Reserve System (FRS) conducted research comparing publicly listed companies and private companies that are considered zombies. The research found that between 2015-2019, there were more zombie corporations among publicly listed companies than among private companies.
Furthermore, government subsidies to companies have also aided the operation of several zombie companies as the government tries to cushion the loss of jobs that will occur if companies close down due to a lack of profitability. Additionally, the low-interest rates on loans enable companies to take on more debt than they can repay and aids them to continue serving as zombie corporations for a longer period. The life expectancy of these companies is also highly unpredictable as they could close up at any time due to their being unprofitable.
Zombie corporations are also known as zombie firms, zombie stocks, zombie companies, or living dead.
See also: Profitability Indicators: Types and Importance
Characteristics of Zombie Corporations and their effects on the economy
Features of zombie corporations
- Zombie companies are usually unprofitable for long periods at a stretch, this makes them unable to pay back the loans they had taken from creditors. A lot of startups wind up becoming zombie corporations due to their inability to effectively utilize the initial funding they get from investors. Most of these startups do not have sustainable business plans to see them through to growth and maturity. Thus, once they no longer get funding, the income they generate is only able to cater to their operations and interest rate payment.
- The performance of these companies is significantly poorer than that of companies within the same industry and keeps deteriorating as time passes instead of improving.
- The interest coverage ratio (ICR) of these firms is generally one or lesser for an extended period of time; usually three years and above.
Below is an example of the income statement of a zombie corporation trailing three years of having an interest coverage ratio of less than one. The formula for calculating the interest coverage ratio of a company is Earnings before interest and taxes (EBIT) ÷ Interest expense
| 2020 | 2021 | 2022 | |
|---|---|---|---|
| Revenue | 80,000 | 95,000 | 89,800 |
| Cost of goods sold (COGS) | 25,000 | 31,500 | 23,800 |
| Gross profit | 65,000 | 63,500 | 66,000 |
| Expenses | |||
| Rent and overhead | 22,000 | 21,000 | 22,800 |
| Salaries | 25,000 | 25,000 | 25,000 |
| Depreciation and amortization | 13,800 | 13,800 | 13,800 |
| Earnings before interest and taxes | 4,200 | 3,700 | 4,400 |
| Interest | 4,500 | 4,500 | 4,500 |
| Earnings before tax | (300) | (800) | (100) |
Effects of zombie corporations on the economy
- The existence of zombie corporations reduces the productive growth of the economies in which they operate, this is because due to their inability to finance any growth and development initiatives, they do not make any significant economic contribution to the economy.
- Due to the inefficiency of funds management and lack of profitability, investors in such companies do not get paid distributions since the company is not profitable talk more of having retained earnings from which dividend payments can be made.
- Competition is stifled since most of these companies keep surviving on government bailouts, thus, companies that should have been more productive become lackadaisical in their business operation.
- Zombie corporations often operate below capacity, hence, they employ a lower number of people than they would have if they were operating effectively and efficiently.
- These companies crowd the market and limit the funding that would have been otherwise available to more productive companies.
See also: Profitability Factors of a Company: What affects profit?
Conclusion
Corporations that generate just enough income to pay the interest on their loans and keep operating but are unable to clear the loans are zombie corporations. They usually do not make enough profits to have retained earnings and as such, cannot finance research, development, and other growth initiatives that could take them out of the zombie classification. These companies depend on continued financing from investors, government bailouts, and low-interest rate payments on loans for their continued survival. Once interest rates rise, most of these companies will either have to declare bankruptcy or stop operating.
Although government bailouts aid zombie companies to keep operating which further preserves jobs, it is often misguided as it does not encourage the company to grow which could lead to an increase in their employment capacity. The loose monetary policies prevalent in the US through low-interest rates, high leverage, and quantitative easing have further contributed to the growth of zombie corporations. These loose monetary policies preserve the growing number of zombie companies as they stifle the growth, innovation, and productivity of corporations. Thus any shift in the market or economy affects these zombie corporations more as it further makes them unable to keep up with their interest rate payments while sustaining operations.
Investors should be on the lookout for companies that have a sustained history of lack of profitability, have no sustainable business growth plans, and have had an interest coverage ratio of one or lesser for a long period of time; usually above three years. Businesses should also ensure they do not take on more debt than they can repay and also ensure that their business plans are executable and that they have adequate growth plans in order to stay profitable and not exist as zombie companies.
