Why is high customer concentration a credit risk and which mitigants are commonly used?

• A. Diversify the customer base; apply concentration covenants; tighten DSCR; obtain additional collateral or guarantees
• B. Increase exposure to the top customer
• C. Rely on government guarantees only
• D. Ignore concentration if profits are satisfactory

Answer: (D)

High customer concentration creates a credit risk because a large share of cash flows and debt service depends on a few customers. If one of those key customers reduces orders, delays payments, or defaults, the borrower's ability to meet interest and principal payments can weaken quickly, even if overall profits look strong. Profits reflect earnings, not the timing and certainty of cash collections from major customers, so concentration risk isn’t fully captured by profitability.

Common mitigants to address this risk include diversifying the customer base so no single client dominates revenue, placing concentration covenants in the credit agreement to limit exposure to any one customer, and tightening the debt-service coverage ratio requirements to ensure a larger cushion between cash flow and debt service. Additional collateral or guarantees can provide a fallback repayment source if a major customer falters. Ongoing credit monitoring of major customers is also a typical part of risk management.

Relying solely on profits, or on government guarantees, or ignoring concentration because profits look satisfactory, does not adequately address the vulnerability. The standard practice is to implement these mitigating measures to reduce reliance on any single customer.