How small business can avoid concentration risk

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When a business relies on just a handful of customers for the bulk of its revenue, it faces increased risk of being affected if just one or two of those customers fails to pay on time or at all. This is known as concentration risk and it’s a very real problem for many Australian businesses, so it’s essential to understand the risk and act to mitigate it.

Businesses face plenty of risk from all directions so it’s important for businesses to be aware of these and do whatever they can to reduce risk in key areas.

There are four key ways that customer concentration can cause problems for small businesses:

1. Instability. Entrusting a business’s financial sustainability to one or two large customers is a recipe for instability. All it takes is for that customer to pull their order or find another supplier and the small business could face insolvency.

2. Over-reliance. If the large customer fails to pay on time (or at all), or uses tricky tactics to delay payments, the knock-on effect could be disastrous. When small businesses aren’t paid on time, it can be difficult to meet debt obligations, pay staff, or buy the necessary stock to continue supplying to the large business.

3. Complacency. When small businesses work with a large organisation that has strong brand recognition, staff can find themselves concentrating more on keeping that customer happy than on finding more customers.

4. Finance barriers. Banks and financiers get nervous when businesses only have one or two large customers, which can make it less likely that the business can secure funding for growth. Even if funding is available, it’s often at a higher rate to reflect the increased risk.

Businesses that recognise themselves in these four risk factors need to act immediately to reduce the risk. There are eight ways to achieve this:

1. Insist on long-term contracts to reduce the risk that the customer will switch suppliers unexpectedly.

2. Allocate resources to grow the customer base, preferably in different industries but certainly with different customers.

3. Add new or different products that can attract a different customer base as well as gain greater share of wallet with existing customers.

4. Be alert to the customer’s payment habits and any industry or environmental factors that could cause late or non-payments.

5. Set payment terms that favour the business rather than the customer and offer incentives for the customer to stick to these terms, reducing the risk of late payments.

6. Position the business to be acquired by the customer.

7. Offer a partnership arrangement where the customer covers the costs of some of the business’s capital overheads in exchange for preferential access to products and services.

8. Take out trade credit insurance to protect the business’s cashflow in the event of late or non-payment. This can also favourably influence lenders’ decisions regarding whether to offer finance and at what rates.

Mark Hoppe, Managing Director ANZ, Atradius