What is a Zombie Company?
A “zombie company” is a term used to describe an uncompetitive company that needs a bailout to operate successfully or an indebted company that is only able to repay interest on its debt (interest-coverage ratio of 1 or less). Such companies generate only enough cash flow to pay the interest on the debt and are unable to reduce the actual principal amount. Therefore, they do not have excess cash or capacity and are stagnant, which means they are too weak to invest or grow.
Below is an example of an income statement of a zombie company. Note that the interest-coverage ratio is less than 1 in each period.
Zombie companies heavily depend on low interest rates to survive. Due to governments and central banks trying to stabilize their economies after a financial crisis, commercial banks are pressured to extend credit and offer low interest rates.
The Origin of Zombie Companies
The term zombie company originated in Japan to describe companies that were only generating enough cash to pay interest on their debts. After the collapse of the Japanese asset price bubble in late 1991, Japanese banks continued to support weak or failing firms instead of letting them go bankrupt. This contributed to what is known as the “Lost Decade,” a period of economic stagnation in Japan.
In 2008, during the Global Financial Crisis, the term regained popularity and was used to describe companies that were bailed out by the U.S. Troubled Asset Relief Program (TARP).
External Risks to a Zombie Company
A sudden change in the business or economic environment can kill zombie companies. If the economy strengthens, more successful companies can quickly take advantage of the opportunities and leave these companies behind. Unable to take advantage of these opportunities, consumer demand for their products or services will decrease, and the companies will eventually encounter significant trouble competing with other companies.
As the existence of zombie companies depends on creditors, a hike in interest rates will wipe out a significant number of zombie firms. The cost of debt will increase, and the companies will be unable to meet their interest obligations.
The Effect of Zombie Companies on the Economy
Zombie companies are seen as a barrier to productive growth, as the survival of weak companies contributes to lowering the average overall productivity. Economists argue that these companies are detrimental to society. They take up market share and lock up talent (“scarce resources”) that should be available to more successful and dynamic companies.
Without cash to reinvest, a zombie company is unable to grow and is inefficient. They are “uncompetitive survivors” and contribute to lower productivity in the global economy.
Although these companies adversely affect the economy, some companies play an important role in the economy. For example, a zombie company may be bailed out by the government simply because the company employs a large number of people. If the company were to go bankrupt, the massive job losses could cause a significant societal impact.
A zombie start-up is a company that receives initial funding but does not receive further investment from investors. A significant number of start-ups become zombie startups – unable to succeed past the early investments.
These startup companies have a short-term plan to secure early investment but lack a long-term plan for growth. As these companies mature, the lack of long-term planning becomes apparent, and the performance of the company drops.
Investors do not see these startups as attractive and, thus, do not allocate additional funds. The company becomes a zombie startup – a company that is still operating after the initial funding runs out but does not actually grow.
Learn about building a financial model for a startup.
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