Concentration and Debtor Finance, What Everybody Ought to Know
A common puzzler for clients and people new to a Debtor Finance facility is Concentration and how it works. In this Video, Daniel gives an inside view on exactly how and when concentration is calculated and why it’s important. Click below to view his tutorial.
Ok today I want to just want to talk about concentration. Concentration really from our point of view is a measure of how concentrated you are to your customers. So If you’re a small business and your dealing with maybe one customer, two customers that’s what’s known as a concentrated account. Because if that customer you’re dealing with for whatever reason decides not to pay ,the risk to your business is massive. And as financier that’s a massive risk for us as well.
So lets just move on how is concentration calculated. The best way to look at this is to use an example. So we’ll use a very simple example. Lets take a small business called Company SME and their existing accounts receivable or their outstanding debtors sits at $100, 000. To make it really simple lets give them 2 customers, now they’ve managed to secure a pretty standard advance rate against their invoice of 80%. In the sales process or the financier in this situation is prepared to do, or they have an internal policy of a maximum of 30% concentration. So their concentration limit is 30%. What that means is no one customer can be more than a maximum of 30% of your total debtor ledger. So how does this calculate? So to work it out what 30% of the maximum ledger is. 30% x 100, 000 which is equal to $30,000. So in this situation the maximum amount of money that this finance company will advance against any one of those debtors is equal to 80%, the trick is to use the advance rate, of $30,000. Which is equal to $24, 000.
OK so pretty simple really, but we must look at, because we have 2 customers, we need to look at what’s the maximum amount of working capital at any one time company SME can get. Because they’ve got 2 customers the maximum amount would be 2 x $24, 000, which is equal to $48,000.
OK pretty simple calculations. Lets look at how that changes depending on how their concentration changes, not the concentration limit but the number of customers they have. So everything else stays the same except they’ve gone from 2 customers and now they have 3. So all the concentration limit stays. The maximum any one customer can be advanced against is $24,000 so we change this here to 3 and this becomes $72,000. 3 x 24 = $72,000.
Just one more iteration of this example to show how, what the advance rate is governed by, what the concentration limit is also governed by. Lets look at what happens if we change the amount of customers to 4. So increase their debtor spread, or we lower their concentration once again, everything else stays the same. Maximum against each debtor is $24, 000. We change this to 4. We should really get $96,000 here, but the reality is the maximum they’ll get with 4 debtors is not $96,000 because don’t forget we’ve only got an advance rate of 80% so really the maximum with 4 debtor is equal to $80,00 total. And that’s how concentration is calculated.
So the next question we want to cover is when is concentration calculated. Well every different finance company has their own policy on how they do it. The reality is it can be concentrated at any point in time; we like to look at it daily. Whenever we are going to do an advance, when ever we’ve got money coming in for a client so we can adjust the book and adjust the risk profile of our portfolio. So one other question I get asked a lot is why is the concentration limit set at a particular rate and once again that varies from debtor to debtor or customer to customer and also from finance company to finance company. Depends on how much risk we’re carrying on our book with that particular customer or how much risk we’re prepared to take. So things such as paperwork, the size of the debtor and also other mitigating factors might be other boot collateral hanging around for the client so other ways, if they only have one customer or one debtor that’s all were financing, most situations are going to need more than a 30% concentration. A way a finance company might get around it is by making sure there’s other collateral such as property or cash sitting around that we can use as security.,
So why does the concentration matter? I’ve had clients ask me many many times. If I’ve got one customer and they’re the best customer in the world, they might be a blue chip international customer, such as Rio Tinto why will you not allow us to do 100% concentration. The reason for that is concentration not only because of the credit risk of the debtor but its also risk of non performance of the contract or dispute from that debtor as well. Even though they might be a BHP or a Rio Tinto or a massive international company with strong credit, that doesn’t mean they’re going to pay their invoice, they could still dispute that invoice and from a finance companies point of view that’s an extreme risk. Thank you very much