Written by Alice Payne
Posted on 23/04/2015

Why dealing with ‘zombie companies’ can lead to more doubtful debt

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Zombie companies are businesses that generate cash but are unable to attract enough investment to pay off their debts. While their income stream enables them to repay the interest on their debts, it doesn’t extend to the capital – which is why their name implies that they’re half dead.

In essence, zombie companies trade through bank loans or finance agreements. Although they may seem liquid from the outside, they’re usually paddling furiously under the surface. Which is precisely what makes it difficult to estimate the number of zombie companies operating in the UK. However, R3 (the association of business recovery professionals) gauges this figure at 146,000 UK businesses.

Our recent climate of low interest rates has provided a supportive environment for zombie companies. However, many argue that these unprofitable businesses are tying up bank loans that could be used by companies that could generate more healthy returns for the economy – particularly as, once interest rates increase, these companies may well go under.

Doubtful debt

Lending to zombie companies presents the danger of exposing yourself to doubtful debt (debt that’s at risk of not being repayed) – or more concerningly, bad debt (uncollectable debt).

Once it’s been identified, doubtful debt can be mitigated to some extent by creating a reserve account – also known as contra account. This allows businesses to ringfence an equivalent sum to the doubtful debt, in anticipation of it becoming bad debt. This means that, if that transition does happens, the lender won’t be left with a hole in their accounts. However, bad debt still represents a financial loss, of course. So the best cure is prevention.

Stagnating the economy

Not only do zombie companies risk contaminating others by failing to repay debt, they can also encourage economic stagnation. Japan’s economic struggles mean that the country has a significant volume of zombie companies. With a view to revitalising the economy, the director general of Japan’s finance ministry's international division, Masatsugu Asakawa, recently told The Telegraph that these businesses were holding back Japan’s recovery.

Any company that's been around for ten years and is still not making a profit should not be doing business,” he said.

“There is a lot of room for Japanese industry to be restructured in every sector and break the [lack of investment] that has been encouraged due to deflation.”

In line with this outlook, last year Japan introduced the Japanese Stewardship Code to encourage companies to support Prime Minister Abe’s deflation-busting economic growth strategy, ‘Abenomics’. However, some argue that, in the short term, these companies still contribute to Japanese employment levels.

Protecting yourself from doubtful debt

So while debate continues about the merit of zombie companies, the key issue is how lenders can protect their loans. There’s no simple formula to guarantee protection from doubtful debt, but by integrating safeguarding procedures to create a robust credit management process, you can minimise the risks.

Firstly, before committing any capital, it’s critical to conduct due diligence. This means carrying out a thorough credit check – both of the business and its directors. You can do this through Companies House or by using the services of a reputable credit reference agency. Secondly, continue to monitor a company’s creditworthiness throughout the duration of your relationship, as a business’s financial health can change rapidly. Thirdly, make sure you know your customer. This means recording their payment trends and liquidity, and staying up-to-date on developments within the industry sector. Lastly, make sure that you act quickly if they fail to stick to your payment terms. The quicker you address the issue, the lesser the chance of doubtful debt transitioning to bad debt.