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The management of accounts receivable can be a complicated task, with direct implications for the firm's bottom line. The credit manager must identify sources of risk and balance potential sales with potential losses when setting credit policy. The firm's business type, financial position, approach to risk, and customer profiles must all be considered when establishing the firm's risk preference. However, all firms can reduce receivable risk by applying the principle of diversification. This article describes an analytic tool that measures the level of diversification in a portfolio of receivables. The concentration ratio measures concentration risk, the degree that a pool of receivables is concentrated in a relatively few accounts.
The benefits of diversification are familiar and generally accepted, as long as payoff prospects are not perfectly (positively) correlated, the risk of the aggregate payoff can be reduced by diversifying over many financial assets. Having a number of customer accounts in and of itself does not ensure diversification. Often, a more complex application of this diversification principle to accounts receivable is problematic because information about customers' payoff probabilities and correlations is generally unavailable or difficult to estimate.It is possible, however, for managers to calculate a summary measure of portfolio concentration which incorporates both number and size of accounts. Further, understanding the measure allows a manager to take steps to improve the level of concentration risk. The following sections describe and define the concentration ratio, and then apply it to estimate the concentration of a large sample of public firms.
The Concentration Ratio
The concentration ratio has a venerable history as a measure of industrial and international trade concentration, and has been applied to bank loan portfolios.2In all cases, it indicates relative diversification, whether of competitors within an industry (i.e., monopoly), of trade with foreign countries, of bank loans, or here, of accounts receivable.
A simple example will help illustrate. Say a firm has five customers with accounts receivable balances. Customer A owes $80, B and C owe $100, D owes $400, and E owes $600. The total accounts receivable balance is $1,280. The amount of receivable dollars concentrated in customer A is 80/1280 or 6.25%; similarly, the amount of receivable dollars in B and C is 7.81% each, in D is 31.25%, and in E...