Business Risk – the dilemma of too much concentration
Concentration of risk too often a serious issue
We learn at our mother’s knee that irrespective of the kind of eggs or basket, putting all our eggs in the one basket is seriously risky.
But too often by the time we’ve gone into business the lesson is forgotten, which is why concentration of risk has become a major issue for domestic business at all levels.
Indeed a nation is at risk when Federal and State economies become dominated by just a few industries and by a handful of big corporations that holds sway in those industries.
Individual businesses can be at risk because of customer concentration, product concentration, industry concentration, economic-sector concentration, supplier concentration and finance concentration.
Panorama of victims
In the past decade there’s been a horizon-to-horizon panorama of victims of one or more of these concentration categories.
The death of the car industry in Australia presents a classic example of fatal industry concentrations.
The GFC caused the collapse of thousands of companies relying on a single vulnerable financier. Importers, exporters, businesses relying on imported components have all suffered the penalty of vulnerability to currency concentration, where a business’s cash flow is exposed to the currency of one country.
Similarly, businesses can be brought to their knees by geographical concentration – for example where they have a concentration of suppliers or customers in a disaster area. For example, consider the financial effects on Real Estate agents and indeed property values in Christchurch, NZ, after the 2011 earthquakes.
Businesses suffer from the effects of supplier concentration when they rely almost exclusively on one supplier stricken by natural or financial disaster. Perversely in a demand boom, a supplier may decide to ration supplies to customers, who as a result find themselves short of inventory or subject to price squeezing.
Managing concentration risk
Every business needs a plan to manage concentration risks. It should identify, measure, and monitor potential risk of all types of concentration relevant to every facet of the business.
Typically, such a plan would take particular care of the company’s top five exposures relative to metrics such as balance sheet, working capital, and net profit, as well as the relative importance to the business of key geographic concentrations.
Not only should the plan monitor these top five exposures to metrics, but their relativity to each other. What could look like a very pleasing number of customers could prove to be a serious problem should it be discovered that virtually all of them are, for example, interrelated through company structures or one particular industry.
Once risks are identified, risk limits should be established in the plan, with regular procedures that alert management to impending breaches. The regularity of the checks should increase as times get tougher.
How to hedge risk
Diversification is one of a SME’s best ways to hedge risk.
Ideally no one customer should be the source of more than 10% of a business’s revenue.
If possible, a business should aim to have customers in at least three different industries, have various suppliers and customers in a range of locations and develop relationships with at least two financiers.
Importers and exporters should look to currency hedges and choose to deal where possible with various companies selling or buying products in the same field.
A business should constantly aim to strengthen its revenue base by fending off poor quality customers with tightening trading terms and conditions that can also be adjusted across an economic cycle in sync with cyclical supply and demand glitches.
Banks manage their portfolio credit risks with regard to industry and to the fluctuating value of collateral and credit worthiness of borrowers. Unless businesses demand cash on delivery, they’re extending credit to customers for varying periods. To that extent, being like banks, they should manage their customers in the same way – setting terms and trading conditions with an eye on a customer’s industry, credit rating and financial situation.
Consider obtaining insurance and guarantees from clients.
For more information, contact Macks Advisory on 08 8231 3323 or visit our office at Level 11, 99 Gawler Place, Adelaide SA 5000.