How to escape 'zombie companies'

Anyone who thinks tax is irrelevant to the way you invest should watch out for a huge loophole companies' ability to claim tax relief on the interest they pay on their borrowings. This bizarre anomaly (dividends paid to shareholders are not tax deductible in the same way) has created what the Evening Standard's Anthony Hilton, among many others, calls "zombie firms".

These are bloated with borrowing, "permanently weakening the business and making it more vulnerable to shocks". How do firms get into such a dire position and how can you avoid them?

The joy of tax relief

Companies like debt for a very good reason: because of the tax relief available, taking on debt turbocharges returns for shareholders. Take two firms, which each make £40m in sales, incur £20m in costs and so have profits before interest and tax of £20m.

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Let's say company A is 100% funded by its shareholders, to the tune of £100m. Company B is 50% funded by shareholder equity, and 50% with debt of £50m. The debt carries an interest rate of 10%. As a result, the profit after interest costs for company A is £20m, while profit after interest for company B is £15m (£20m profit minus £5m interest).

Now comes the tax dodge. Say both firms pay corporation tax at a rate of 25%. Company A suffers a tax charge on its profits of £5m (£20m x 0.25). So its profits after interest and tax are £15m (£20m-£5m). Company B gets to offset £5m of interest before being hit for tax. This means its corporation tax charge is based on profits of £15m, so its tax charge is £3.75m (£15m x 0.25) and its profits after interest and tax £11.25m (£15m-£3.75m).

Here's the point what is the return on equity for each? For the 100% equity funded firm it's a respectable 15% (£15m/£100m). But for the debt funded firm it's 22.5% (£11.25m/£50m). Yet both firms made the same profit and started out the same size and even do the same thing!

As Allister Heath notes in The Daily Telegraph, "firms with lots of debt pay less corporation tax than those with none, even if the companies are identical in every other way". This is madness: it encourages the likes of private-equity firms to load up companies with lots of debt in a rising market, squeeze out dividends while they can, and leave a debt-laden husk at the end of it.

Hilton would like to see one immediate change to the system: abolish corporation tax relief on debt. As he says, "equity investment would get a boost, which would make British business more soundly based and better focused".

How to avoid buying a zombie

Sadly, this kind of reform isn't about to happen overnight there are too many vested interests benefiting from the status quo. So in the meantime, the fastest way to spot a debt-bloated zombie is by looking at the gearing ratio and interest cover.

Gearing is the relationship between debt and equity funding as a percentage. So using my two firms, company A had gearing of 0%, while company B had gearing of 50%. You might like a bit of gearing during a rising market, as it boosts returns, but in today's volatile markets, low gearing is generally a good sign.

Also check interest cover a company's ability to pay interest out of profits. In my example, company A has no problems, as there was no interest bill to cover. Company B had profits before interest of £20m and a £5m interest bill. So cover is £20m/£5m, or four times.

The absolute minimum I would accept in today's climate is two to three times. Anything less and you could end up with a zombie.