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We take a look at the rise of the zombie and why it’s best to avoid them.
This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
A zombie company is a business which is able to pay the interest on its debt but isn't able to repay the principle loan without turning to shareholders for extra cash.
Specifically, a zombie company might be making profit, with more sales than costs like wages and inventory, but all of that profit is paying the interest of its debt pile.
This should not be viewed as personal advice, please ask for advice if you are not sure.
A company like this doesn't have the cash to invest in future growth. Significant debts and no way to build up spare cash can also leave superficially healthy companies very vulnerable to unpleasant surprises.
Put those two things together and a company which is stuck in the zombie zone for any length of time will struggle. To turn itself around it would need either a dramatic change of market conditions or to turn to investors for extra cash.
Betting on the former is risky, while the latter is potentially painful – as new shares are issued to investors at lower prices, significantly diluting existing investors shares.
The number of zombie companies shot up in the pandemic. That was because of a combination of things, but restrictions heaped huge pressure on many companies, especially the travel sector.
Source: Refinitiv * "Zombie" as measured by companies whose interest expense is greater than operating profit. Data as of July 2023.
But while the very worst of the pandemic pain is now gone, another problem is biting. Higher interest rates massively increase the risk for companies with high debt. Many firms have been able to avoid serious financial pain through cheap borrowing costs, but this is no longer the case. Essentially, this means there's nowhere to hide now if your debt levels are too heavy.
Companies are bearing the scars of higher costs and weakening demand because of inflation. This combination can encourage companies to take on debt.
2,552 companies filed for insolvency in May, which was 40% more than a year before and the highest since the financial crisis. It was also higher than during the pandemic – when companies were being propped up by government support.
This huge figure takes into account UK-wide registered businesses, rather than just listed companies, but it shows how difficult conditions are.
In normal times investors pay lots of attention to operating profit, sometimes called earnings before interest, tax, depreciation and amortisation (EBITDA), but less to profit after tax.
You can understand more about income statements and more detail on different types of profit with our specialist investor's guide.
But, there's also a quick and easy ratio you can calculate to get an idea as to how well a company can cover its interest costs. The interest coverage ratio, which takes operating profit (EBITDA) and divides it by interest expense. Anything under 1 is in zombie-land, ideally you want this to be high single digits at least.
The dramatic changes to some corporate balance sheets in recent times means investors can't afford to be complacent. Companies that stay stuck in zombie mode as the economy steadies should have a very good reason to make it onto your investment list.
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