The Walking Debt: Beware of Zombie Companies

In the wake of a tumultuous economy and consistent interest rate hikes, more companies are under significant financial distress, struggling to pay debts and survive. This has given rise to “zombie companies”—businesses that are able to continue operating but are essentially insolvent and no longer profitable. Zombie companies serve as a chilling reminder of the complexities and challenges lurking within the economic landscape.

“A zombie company means they’re dipping into their cash reserves despite having some strength in revenues,” said NACM Economist Amy Crews Cutts, Ph.D., CBE. “So, it’s not a length of time, it’s relative to how much they have in assets. A zombie company could be going through its assets very quickly with their chances of surviving diminishing by the day.”

According to CEPR, zombie firms accounted for 10% of all listed firms in 2021. But the percentage of companies in the U.S. considered a zombie company grew to 13% in 2022, according to Goldman Sachs. “What is special about the current environment is that zombification has been increasing over time, particularly since the global crisis and the COVID-19 pandemic,” reads the article. “In perfectly competitive markets, unproductive and unviable zombie firms would exit the market, allowing healthy firms to operate more efficiently, while promoting the entry of new productive firms. But, as the literature has documented, misaligned incentives on the part of lenders (banks, investors, or governments) allow zombie firms to avoid immediate default.”

Stimulus checks and relief funding during the pandemic kept many failing businesses afloat for longer periods, but now that safety net is gone, said Jeff Weber, director of credit at Uline (Pleasant Prairie, WI). “With consumers being more cautious in their discretionary spending, higher interest rates as a result of the Fed and banks or investors tightening up their lending standards, it’s created an environment for these zombie companies to now fail.”

Although the definition of a zombie company changes depending on who you’re talking to, its consequence remain the same—zombie companies slow economic growth, drain resources available for healthy companies and prevent investors from pursuing better opportunities elsewhere.

Signs You Have a Zombie Customer

Small publicly listed firms: These companies have lower return on assets, hold less cash and have lower investment opportunities than their non-zombie counterparts. “For private firms, the average zombie firm is comparable in size, but is less profitable and holds less cash than other firms. With the exception of asset size for private firms, the p-values of equality of medians for zombie and non-zombie firms indicate that these differences are not only economically large but also statistically significant,” reads a report by the Federal Reserve.

Interest-coverage ratio of 1 or less: Companies in that range generate only enough cash flow to pay the interest on the debt and are unable to reduce the principal amount. Therefore, they do not have excess cash or capacity and are stagnant, which means they are too weak to invest or grow. Or if their earnings before interest, taxes, depreciation and amortization (EBITDA) are less than their interest expense.

Slower payments or extending terms: If a customer is not able to service its debt, they will not be paying on time and will start asking for longer credit terms than previously arranged.

Withholding information: Companies that aren’t willing to share financials or refuse an account review may be hiding financial distress. “This could mean they are having financial difficulties and not sharing information for fear that if they show you, you won’t do business with them,” Cutts said.

Sudden acquisition of companies: If a company is acquiring a lot of other companies, they’ll try to push off the debt on the acquired company instead of carrying it on their own books, said Esther Hale, ICCE, senior analyst and treasury-global credit at Phillips 66 Company (Bartlesville, OK). “A lot of zombie companies look to private equity companies for funds that don’t always have the company’s best interest in mind and may be looking to have an opportunity to take it over and keep the good parts and get rid of the dead weight. I had one recently that did that and took on too much debt. They are not bankrupt yet, but I worry about how much longer they can survive.”

What Creditors Can Do to Mitigate Risk

One of the ways credit professionals can mitigate risk with zombie customers is consistent financial statement review, especially for high-risk industries and customers, Weber said. “As well as monitoring liquidity, leverage and coverage ratios. For retailers, monitoring same store sales and how it is trending.”

The growing threat of zombie customers underscores the importance of ongoing credit checks, even for existing customers. Cutts advises that trade creditors use business information companies to their advantage when onboarding new customers. “You can do an account review directly with your client, but you can also do an account review behind the scenes with data providers that would indicate whether liens have been filed against the company, whether lawsuits have been filed against the company or there’s been a management shakeup because that can also affect the reputation of the company,” she said.

Industry credit groups are also a useful resource so you can compare customer information with others in the same field of business. “Talk to other vendors that have a common customer and find out whether or not they’re late with other customers and vendors,” Jason Torf, Esq., partner at Tucker Ellis LLP (Chicago, IL). “It doesn’t necessarily mean that they’re not able to service their secured debt, but it should help you find out what’s going on and why they’re unable to pay on time.”

Credit professionals are the investigators of the financial world. Asking questions will help you figure out where a company stands financially. Hale asks customers how they’re making money or acquiring business. “I also ask if there are multiple businesses and if they are integrating them,” Hale said. “Are they trying to make theirs bigger? Are they growing too fast? The larger the company, the larger the credit limits are extended to customers while the smaller the company, the smaller the credit limits. But no matter the size, knowing your customer will help them meet financial obligations and make sure you receive payment.”