Live by the Concentration, Die by the Concentration

I once had to review a line of credit renewal for a business that manufactured home improvement materials (siding, gutters, weather stripping, etc.). The business was doing very well and then tanked, and the previous underwriter said the recession was to blame. Upon reviewing the financials, it was obvious to me the company saw a slow-down during the recession but continued to operate profitably. Later on, an extreme drop in revenue came well after the recession.

I had an opportunity to sit down with the company officers and talk to them about this phenomenon. As they explained it, they had one major corporate buyer for nearly all their products, and that company decided to switch suppliers. And just like that, the borrower lost the majority of its business overnight and failed to operate profitably since.

When we look at financing businesses, it is not enough to know how effectively the business operates; we also need to understand who they are selling to. If a business has a concentration of sales to a single customer, then that customer presents a unique credit risk to the business, which means it becomes a credit risk to the credit union as well.

Part of the underwriting process should be to check for customer concentrations. Generally, a concentration is usually any customer that makes up 10% of sales or more. A customer concentration alone is not necessarily a bad thing, but it means that further underwriting considerations are needed. The big question we must ask is, whether the business could reasonably deal with a loss of one or more of their customers with whom they have a concentration? And, is there any information we have that speaks to the financial wherewithal or credit worthiness of that customer?

Red flags arise when the business is overly reliant on the concentration of sales, especially when the business is providing a specialized product or service for which there would be no other demand outside of the customer with the concentration. Take, for example, someone doing consulting for NASA that specializes in the space shuttle. When NASA no longer has use for the space shuttle, that consultant will not have a use either, and the consultant will have nobody else to provide that specialized support to.

The most common way to check for customer concentrations is to request an accounts receivable aging report. This will provide a list of customers, how much they owe, and when the customer was billed. From this list, you can see if one customer’s billings tends to comprise a significant amount of total billings, which would indicate a concentration. Another way is to obtain a backlog report of work orders or contracts to see what works.

Just like most underwriting, the question that needs to be answered is what will happen in the worst case scenario. If the borrower loses a customer concentration or fails to collect from that customer, what will ultimately happen? Can the business remain profitable without the concentration? Does the business have the equity to absorb the loss? Does the guarantor have the personal resources to prop up the business if need be? If the answer to all of those questions is “no”, then your ultimate source of repayment is too heavily dependent on a customer concentration.