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Oct 30, 2024

Counting the undead: A new metric for identifying zombie firms | CEPR

Zombie firms are poorly performing firms that are unable to service their debt obligations over a prolonged period. They have a marginal return on capital that is below the risk-adjusted market cost

Zombie firms are poorly performing firms that are unable to service their debt obligations over a prolonged period. They have a marginal return on capital that is below the risk-adjusted market cost of capital (Schivardi et al. 2022), and often survive due to bank support.

Caballero et al. (2008) identify zombie firms as those that received subsidised credit, defined as paying a lower interest rate than the interest rate paid by the highest quality borrowers (AA-rated or higher). Andrews and Petroulakis (2017) and McGowan et al. (2018), on the other hand, define zombies as firms that are at least ten years old and have an interest coverage ratio (earnings before interest and taxes to financial expenses) below one for three consecutive years. We refer to this as the ‘OECD definition’. Other researchers have identified zombie firms using a combination of the above with other firm performance measures, such as: (i) firm profitability (e.g. Schivardi et al. 2022), (ii) negative equity (Bonfim et al. 2023), (iii) low interest coverage ratio (e.g. Acharya et al. 2019, 2024), or (iv) leverage (Acharya et al. 2024). For an overview, also see Albuquerque and Iyer (2023).

In De Jonghe et al. (2024), we suggest a new approach to identify zombie firms. Our approach is based on recurring cash flows and longer term, structural underperformance, and builds on the ‘OECD definition’. A firm is classified as a zombie if three conditions are met:

We focus on recurring cash flows. The first main difference is thus the use of earnings before interest, taxes, depreciation, and amortisation (EBITDA) rather than EBIT to measure operating cash flows. As interest expenses are a cash outflow, operating earnings (EBIT) is not a good indicator of a firm’s ability to service its debt due to its inclusion of depreciation and amortisation which do not generate cash outflows. Additionally, firms that invest more will likely have higher levels of depreciation, resulting in lower EBIT and a higher likelihood of being classified as a zombie firm, which is counterintuitive. Rodano and Sette (2019) also made this point in the context of Italian firms. Furthermore, depreciation and amortisation practices are highly industry-specific (see Figure 1, upper panel), which distorts comparisons across industries and possibly also across countries if these differ in their industrial composition.

The second difference is that we include financial revenues. Financial revenues (e.g. from T-bills or intercompany loans) are often recurring and can also be used to service interest expenses. In addition, financial revenues tend to be more prevalent in large firms. Excluding these revenues might induce biases, inflating the probability of classifying large firms as zombies and hence also the total share of capital and labour in the economy that is stuck in zombie firms. Lastly, financial revenues are industry-specific (see Figure 1, lower panel).

Figure 1 Share of depreciation/amortisation and financial revenue in EBITDA

A) Industry-average depreciation and amortisation

B) Industry-average financial revenues

Finally, our classification requires that recurring cash flows are structurally insufficient to meet interest expenses. Rather than assessing the condition year-by-year over a three-year horizon (as in the OECD definition), we assess whether three-year cumulative recurring cash flows are sufficient to cover three-year cumulative interest expenses. With this adjustment, we avoid incorrectly classifying firms as healthy if they have a one-off improvement in cash flows or a one-off reduction in interest expenses. 1 To further smooth the impact of one-off events, we additionally impose that annual recurring cash flows should fail to cover interest expenses in at least two of the three years.

Each adjustment has important consequences for classifying a firm as a zombie or not, as can be seen in Figure 2. Starting from the ‘OECD definition’ (red, solid line, circles), we see that adding financial revenues (orange, long-dash, squares) and starting from EBITDA rather than EBIT (orange, short-dash, diamonds) substantially reduces the share of zombie firms. Finally, adding the structural changes that bring more persistence to the classification (green, solid line, triangles), leads to a meaningful increase in the number of zombie firms. Overall, compared to the ‘OECD classification’, our classification estimates a much smaller and less cyclical share of zombie borrowers in the economy: 3.4% instead of 10.4%.

Figure 2 Fraction of zombie borrowers: Step-by-step definition adjustments

Comparing our definition with the OECD definition partitions the sample into four groups: i) firms that both definitions classify as healthy, ii) firms that our definition classifies as healthy but the OECD definition as zombie, iii) firms that our definition classifies as zombie but the OECD definition as healthy, and iv) firms that both definitions classify as zombie. The latter represent 2.4% of the total sample and we take it as our reference group.

Relative to the reference group, we find that:

Interestingly, while we do not impose a solvency or growth criterion in our zombie classification, we are picking up firms with similar characteristics as used by some of the alternative zombie definitions in the literature: namely, they have higher leverage, are more likely to have negative equity, and have lower growth potential as they invest less in physical and human capital and exhibit lower future sales growth.

Some alternative zombie definitions, like the ones suggested by Caballero et al. (2008) and Acharya et al. (2019, 2024), require zombie firms to be charged interest rates below those of the best-rated firms in the economy (AA-rated or higher). Our zombie classification does not impose such a requirement. In fact, we find that firms that we identify as zombie firms pay an interest rate that is on average 125 basis points higher than healthy firms. However, despite paying a higher interest rate, this may still imply that they receive a subsidy if it does not sufficiently compensate the bank for zombie firms’ default risk.

To estimate whether zombie firms potentially receive such an interest rate subsidy, we conduct a back-of-the-envelope calculation like De Marco et al. (2021). The calculation is based on the logic that, in equilibrium, banks should set interest rates such that the expected return on loans to zombie firms equals the expected return on loans to healthy firms (and equals their marginal costs of capital), hence factoring in differences in probability of default as well as loss given default.

Our back-of-the-envelope computation suggests that banks should charge zombie firms 270 basis points more than healthy firms on their debt borrowing to have the same risk-adjusted expected return. However, as banks only charge them 125 basis points more, this implies that the average zombie firm enjoys an interest rate subsidy of about 145 basis points.

Hence, although our identification does not include a requirement regarding interest rate subsidisation, it does seem to be consistent with a ‘weak’ concept of subsidisation, namely the firms we identify as zombies pay an interest rate that is (significantly) lower than justified by their risk. This is in line with, but different from, Caballero et al. (2008) and Acharya et al. (2019, 2024), who identify zombie firms using a ‘strong’ concept of interest rate subsidisation, i.e., paying an interest rate that is lower than the interest rate that the least risky firms pay.

Acharya, V, M Crosignani, T Eisert and C Eufinger (2024), “Zombie Credit and (Dis-)Inflation: Evidence from Europe”, The Journal of Finance 79: 1883–1929.

Acharya, V, T Eisert, C Eufinger and C W Hirsch (2019), “Whatever It Takes: The Real Effects of Unconventional Monetary Policy”, The Review of Financial Studies 32: 3366–3411.

Albuquerque, B and R Iyer (2023), “The Rise of the Walking Dead: Zombie Firms Around the World”, VoxEU.org, 28 August.

Albuquerque, B and C Mao (2023), “The zombie lending channel of monetary policy”, VoxEU.org, 6 October.

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Caballero, R J, T Hoshi and A K Kashyap (2008), “Zombie Lending and Depressed Restructuring in Japan”, American Economic Review 98: 1943–1977.

De Jonghe, O, K Mulier and I Samarin (2024), “Bank Specialization and Zombie Lending”, Management Science.

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McGowan, A, D Andrews and V Millot (2018), “The Walking Dead? Zombie Firms and Productivity Performance in OECD Countries”, Economic Policy 33: 685–736.

Rodano, G and E Sette (2019), “Zombie Firms in Italy: A Critical Assessment”, Unpublished working paper, Bank of Italy.

Schivardi, F, E Sette and G Tabellini (2022), “Credit Misallocation during the European Financial Crisis”, The Economic Journal: 391–423.