The Rise of 'Zombie Companies'

How the COVID-19 Pandemic and Government Policies are Impacting the Construction Industry in Australia.

Are you running a zombie company?

The COVID-19 pandemic led to some extreme behaviour by governments around the world.

From lockdowns to cash handouts, decisions have been made quickly by those in power and at the expense of our future selves. 

In the United States, between 5%-10% of all companies are estimated to be zombie companies.

One decision that flew under the radar in Australia was an amendment to legislation, allowing directors of insolvent companies to continue trading legally and without fear of prosecution. 

While that may have seemed like a good idea at the time to a government that was giving away free cash as fast as they could print it, the consequence of that decision was an explosion in the number of zombie companies continuing to operate and providing unfair competition to healthy companies.

What Are "Zombie Companies"?

According to SK Law, “A zombie company is defined as a business that barely scrapes by and is always short of cash. In accounting terms, it covers most of its running costs but is never able to develop a profit margin.”

Sound familiar?

The problem with "zombie companies" operating in the construction industry is that they are not teetering on the edge, they are fully submerged beneath a mountain of debt, which is not always apparent from the outside due to the huge amounts of positive cash flow that are generated from new construction. 

So, instead of being "zombie companies," they are really nothing more than construction Ponzi schemes - businesses that rely on new sales to pay old debts.

However, it would be wrong to assume that all builders operating these types of businesses are crooks. The vast majority are simply unaware of how bad the situation really is because they are not producing accurate financial reports on a regular basis.

Deep analysis by the Association of Professional Builders suggests that up to 90% of residential building companies have not been correctly trained in the art of producing accurate financial reports that reveal true net profit as opposed to simply accounting for cash.

The consequences of allowing unprofitable construction companies to continue operating in our industry are dire for consumers, subcontractors, suppliers, and even other builders.

The Consequences For The Construction Industry

For consumers, subcontractors, and suppliers, it can be difficult to determine if a building company they are dealing with is financially stable or running on fumes. 

Prior to the pandemic, it was generally accepted that larger building companies were safer bets than smaller operators, and were less likely to be placed into administration partway through a build. 

However, the pendulum has swung, and those large building companies that signed excessive amounts of contracts during the 2020-2021 frenzy - all on fixed-price contracts - went on to lose their shirts in the 18 months that followed.

As a consequence, some were forced to close their doors, others scrambled to raise additional capital to prop up their cash flow, but many soldiered on, and having destroyed their reserves, are now reliant on new sales to pay off old debts. 

Oddly enough, those directors will not face prosecution because, although they are operating a construction Ponzi scheme, they are still managing to trade solvently by paying their bills as and when they become due and payable.

So long as sales continue to flow in, these companies will be able to continue trading without detection. 

Bernie Madoff managed to operate without making a profit for over twenty years, highlighting just how difficult these schemes are to identify, especially when the authorities do not have the desire to investigate properly, which is what we are seeing in the residential construction industry.

It’s been claimed that the licensing authorities are aware of the situation but are concerned that if they enforced their own requirements, they would destroy more than half the residential construction industry overnight. 

However, by allowing these companies to continue chasing cash flow in order to prop their companies up for another year, they are unwittingly creating unfair competition for the hundreds of professionally-run building companies that operate on sustainable margins and hold sufficient cash reserves to cover all of their liabilities regardless of what is happening in the economy.

One of the most frustrating things about "zombie companies" and construction Ponzi schemes is that those building companies can usually be turned into profitable businesses. 

However, because the companies focus on cash in the bank rather than accrual accounting, they generally never realize the seriousness of the situation until it is too late.

The Need For Transparency

This is why we need full visibility of every residential construction company's accounts and compulsory financial education for building company owners. 

If a building company's financial statements were a matter of public record, then consumers, subcontractors, and suppliers would be in a position to make their own assessment of a building company's financial situation, rather than having to rely on the licensing authorities to make that assessment for them.

Additionally, it makes sense that if the owner of a building company is generating huge amounts of positive cash flow while operating on razor-thin profit margins, then they should be required to have a basic understanding of construction financials and, in particular, how to calculate the real amount owed to creditors on each project, rather than just the amount that shows up in their accounts.

We place very numerous requirements on builders to attend education sessions that ensure they are always up-to-date on changes to the national construction code. However, there is no requirement for builders to have an understanding of their accounts.

In order for this industry to improve for both builders and consumers, we need to eliminate the bad actors and reward the professional building companies.

Building companies that have grown safely and securely over the past few years and will continue to do so by operating on healthy profit margins while generating more demand for their services than they can supply.

If that sounds like the kind of building company you would like to be operating, then check out these proven systems.